What is ABC (Activity-Based Costing)?

“Definition of terms is the beginning of wisdom”. (Albert Einstein).

Many different terms are used by businesses to describe cost allocation in practice. You may encounter terms such as allocate, attribute, reallocate, trace, assign, distribute, redistribute, load, burden, apportion and reapportion, which can be used interchangeably to describe the allocation of costs to cost objectives. In essence, Activity-Based Costing (ABC) firstly allocates costs to activity cost pools and then to cost objects applying activity cost drivers.

“What cannot be measured, cannot be controlled.”

Activity-Based Costing (ABC) is also defined as a methodology that measures the cost and performance of activities, resources and cost objects.

Specifically, resources are assigned to activities, then activities are assigned to cost objects based on their use. ABC recognizes the causal relationships of cost drivers to activities (Institute of Management Accountants, 1998).

ABC & M systems provide financial and non-financial information of high standards giving excellent insights to facilitate and support fundamental issues in any enterprise such as, inter alia, management of cost, time, quality, funds, strategic planning and constraints management.

“ABC & M is therefore not just a new way of computing business figures but requires the fundamental understanding of all management issues. It is about understanding and not about calculations.

It is clear that organizations which do not adapt to the new methodologies will, in future, experience substantial difficulties in being competitive and remaining in business.” (Activity-Based Costing and Management – E. Glad and H. Becker; 1994)

The formal system for controlling costs by activity is referred to as Activity Based Costing (ABC).

When it comes to controlling costs, most organizations control costs by general ledger account, i.e. they analyse and interpret their Income Statement. This short-sighted approach to cost control often leads to the destruction of value within the so-called value chain. A simplified example is, when you cut people, the activities they perform may still be there, but no one’s around to perform the activity. So you end-up creating black holes and anorexia in the organization that destroys employee value. Once you’ve destroyed employee value, this leads to poor customer service and hence, the destruction of customer value. Now that you’ve lost your customers, this translates into the destruction of shareholder value. So you end-up destroying value within the entire value-chain: Employee, Customer and Shareholder.

A better approach is to control your costs by activity.

Under this approach, you now analyse and interpret your costs by activity, such as costs to process customer orders, costs to run payroll, costs to recruit new employees etc. In this example, the key is to reduce costs that fail to serve internal or external customers. For example, you can easily do this by simply focusing on re- doing activities i.e. re-type the letter, re-inspect the pipe, re-enter the accounting entries, etc. By eliminating unnecessary re-doing activities, you will improve your process immensely and cut costs at the same time.

Activity-based costing (ABC) systems first accumulate overhead costs for each of the activities of an organization, and then assign the costs of activities to the products, services, or other cost objects (CO) that caused that activity.

Activity-based costing (ABC) is an accounting method that allows businesses to gather data about their operating costs (overhead costs) and a continuum of value. Costs are assigned to specific activities and then the activities are associated with different products or services, termed cost objectives (CO). In this way, the ABC method enables a business to decide which products (CO), services (CO), and resources are increasing their profitability, and which are contributing to losses. Management are then able to generate data to create a better budget and gain a greater overall understanding of the costs that are required to keep the company running smoothly.