Regardless of your industry, Activity Based Costing is an important accounting methodology. In this how-to guide, we’re going to look at the ABC of… ABC!

Activity-Based Costing

Activity-Based Costing, abbreviated simply to ABC, is a method of cost accounting that helps businesses to price their products and services in a very accurate way. It’s most often used by large manufacturing companies, but it can offer real value to smaller companies too.

How ABC works

With this method, the user assigns specific costs to individual products and services as part of managerial accounting processes. This means assigning individual costs to certain tasks, rather than apportioning them more generally across departments or cost centres.

ABC isn’t easy, and it usually requires a qualified accountant. The methodology works by:

  1. Identifying every activity required to produce a product/service.
  2. Separating standalone activities in cost pools – for example, you might have a cost pool for purchasing, which could include purchase order creation and administration, stock receipt and stock management and warehouse employee salaries.
  3. Assigning a single cost driver to every activity. For example, a product assembly cost driver could include machine operation measured in uptime hours.
  4. Calculating overhead rates at a predetermined rate; dividing total overhead cost estimations by cost pool drivers.

How ABC differs from traditional cost accounting

Activity-based costing is different from traditional methods of cost accounting. With traditional methods, businesses decide a fixed percentage of their overheads and cost of goods sold (COGS) – or combine the two into a standard figure.

With ABC, the business gets to see the true and accurate cost of producing a certain product or service – in a clear and transparent way. In this way, the business can assess:

  • which of its products or services are profitable,
  • which are priced correctly (or require a price adjustment
  • whether any products or services are unprofitable and, potentially, unviable (for a profit-making business.)

Operational gains of Activity-Based Costing

Although Activity-Based Costing is often associated with large manufacturers, it often has value for smaller businesses. This is because accurate costing methods can more immediately impact business profitability for a smaller company with a tight budget; whereas bigger firms tend to have more leeway when assessing their product costs and assigning overheads.

Other benefits include:

1. Better product pricing

Cost of Goods Sold (COGS) calculations cover the direct costs of sale, but indirect costs need to be factored in. ABC forces businesses to assign a cost to every single production activity per product, to enable better pricing.

2. Improved production

ABC also flags up where risks exist in production, particularly with inefficient processes and duplicate tasks. For example, you may find that your older ‘cheaper’ machinery is actually costing you more in delays and repairs than the current models. You may find that your suppliers have also been raising their prices, and you have not fully factored the impact of these raises into your own production. ABC turns over every stone and shines a light on what’s really happening in your business.

3. Better managed overheads

Activity-based costing also looks at fixed costs like utilities, rent and lease agreements. So if your draughty ‘low-cost’ warehouse is actually costing a fortune to heat and secure, the resulting data will pinpoint areas for further investigation.

But note; ABC doesn’t manage for you!

It’s important to note that Activity-based costing may be powerful, but it’s not a fix-all. It doesn’t tell you what course of management action you should take, but it does make you aware of the relevant costs, so you can make a more informed, accurate decision that uses relevant data.

The strategic value of Activity-Based Costing

Activity-based Costing provides vital business data in a clear, whole and transparent way. It allows decision-makers to make informed assessments about the profitability of their product and service lines, and to use these profitability indicators to decide which product lines should be promoted and which might be ready for withdrawal altogether (although for some organisations, there may be other reasons for continuing to offer loss-making products or services.) The important thing is that the transparency offered by ABC allows managers to make informed and strategic decisions which keep the whole picture in mind.

The importance of a good KPI management tool

Activity-based costing is a valuable management tool which can be leveraged within an organisation to help it achieve its strategic goals.

It falls within an arsenal of functional tools that most businesses will use – perhaps one of the most important of all being a robust KPI management tool, which allows the organisation to track the progress and achievement of its strategic KPIs.

Sometimes businesses become focused on individual functions, departments or operational targets. KPIs keep everyone focused on the most important strategic objectives; those which are key to strategic performance and achievement of the strategy itself.

Our preferred tool

Various tools exist on the market to track KPIs, and the one we recommend is called Spider Impact. It’s a fully-automated and highly powerful system that integrates with your business to generate tailored KPI reports in real-time. What’s more, it’s simple and intuitive to use and enables managers at all levels to mine into data that helps them make better, more informed business decisions.

You can test out Spider Impact for yourself on a no-obligation basis for thirty-days. The system is already used by hundreds of successful businesses across the world, and we believe that it is a superb tool for easy, clear and powerful KPI management.

Note: Spider Impact is not an Activity-Based Costing tool, it can be used in conjunction with an accounting tool to extract KPIs to make useful management decisions.

Find out more

Intrafocus helps organisations of all sizes and industry to develop successful business strategies. Our team of experienced consultants can help unlock value for your business, regardless of what stage your existing strategy is at. We can work on a remote basis to support Covid-safe working, and flex according to your needs. Please contact us to find out more.