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Activity-based costing
Jun 29th 2009 | Online extra
Timekeeper
Activity-based costing (ABC) is a method of assigning costs to products or services
based on the resources that they consume. Its aim, The Economist once wrote, is �to
change the way in which costs are counted� (see article).

ABC is an alternative to traditional accounting in which a business's overheads

(indirect costs such as lighting, heating and marketing) are allocated in
proportion to an activity's direct costs. This is unsatisfactory because two
activities that absorb the same direct costs can use very different amounts of
overhead. A mass-produced industrial robot, for instance, can use the same amount
of labour and materials as a customised robot. But the customised robot uses far
more of the company engineers' time (an overhead) than does the mass-produced one.

This difference would not be reflected in traditional costing systems. Hence a

company that makes more and more customised products (and bases its pricing on
historic costings) can soon find itself making large losses. As new technologies
make it easier for firms to customise products, the importance of allocating
indirect costs accurately increases.

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Cost-cutting activity
Jul 30th 1998
Introducing activity-based costing is not a simple task�it is by no means as easy
as ABC. For a start, all business activities must be broken down into their
discrete components. As part of its ABC programme, for example, ABB, a Swiss-
Swedish power company, divided its purchasing activity into things like negotiating
with suppliers, updating the database, issuing purchase orders and handling com-
plaints.

Large firms should try a pilot scheme before implementing the system throughout
their organisation. The information essential for ABC may not be readily available
and may have to be calculated specially for the purpose. This involves making many
new measurements. Larger companies often hire consultants who are specialists in
the area to help them get a system up and running.

The easy approach is to use ABC software in conjunction with a company's existing
accounting system. The traditional system continues to be used as before, with the
ABC structure an extra to be called upon when specific cost information is required
to help make a particular decision. The development of business accounting software
programs has made the introduction of activity-based costing more feasible.

Setting up an activity-based costing system is a prerequisite for improving

business processes and for any re-engineering programme (see article). Many firms
also use ABC data for the measures required for a balanced scorecard (see article).

Activity-based costing became popular in the early 1980s largely because of growing
dissatisfaction with traditional ways of allocating costs. After a strong start,
however, it fell into a period of disrepute. Even Robert Kaplan (see article), a
Harvard Business School professor sometimes credited with being its founding
father, has admitted that it stagnated in the 1990s. The difficulty lay in
translating the theory into action. Many companies were not prepared to give up
their traditional cost-control mechanisms in favour of ABC.

In 2007 Kaplan brought out a new book that tried to make activity-based costing
easier. Called TDABC (time-driven activity-based costing), it attempted to relate
the measurement of cost to time. As Kaplan put it, only two questions need to be
answered in TDABC:

� How much does it cost per time unit to supply resources for each business
process?

� How much time is required to perform the work needed for a company's products,
transactions and customers?

Nevertheless, ABC has many satisfied customers. Chrysler, an American car

manufacturer, claims that it saved hundreds of millions of dollars through a
programme that it introduced in the early 1990s. ABC showed that the true cost of
certain parts that Chrysler made was 30 times what had originally been estimated, a
discovery that persuaded the company to outsource (see article) the manufacture of
many of those parts.

Further reading

Kaplan, R.S. and Cooper, R., �Make Cost Right: Make the Right Decisions�, Harvard
Business Review, September�October 1988

Kaplan, R.S. and Cooper, R., �Cost and Effect: Using Integrated Cost Systems to
Drive Profitability and Performance�, Harvard Business School Press, 1997

Kaplan, R.S. and Anderson, S., �Time-Driven Activity Based Costing�, Harvard
Business School Press, 2007

Ness, J.A. and Cucuzza, T.G., �Tapping the Full Potential of ABC�, Harvard Business
Review, July�August 1995

More management ideas

This article is adapted from �The Economist Guide to Management Ideas and Gurus�,
by Tim Hindle (Profile Books; 322 pages; �20). The guide has the low-down on over
100 of the most influential business-management ideas and more than 50 of the
world's most influential management thinkers. To buy this book, please visit our
online shop.

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