Activity-based costing

Activity-based costing (ABC) is a costing model that identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each. It assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

In this way an organization can precisely estimate the cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced.

In a business organization, the ABC methodology assigns an organization's resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.

Direct labor and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The measure of the use of a shared activity by each of the products is known as the cost driver. For example, the cost of the activity of bank tellers can be ascribed to each product by measuring how long each product's transactions takes at the counter and then by measuring the number of each type of transaction.

Activity-Based Costing (ABC) arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the overhead costs in companies were generally very low compared to today. However, from the 1960s - particularly 1980s - this changed rapidly. For these reasons, and more, traditional cost accounting has been called everything from 'number 1 enemy of production' and questions whether it is 'an asset or a liability' have been raised. ABC has been called one of the most important management innovations the last hundred years.

Activity based costing has grown in importance in recent decades because
1. manufacturing overhead costs have increased significantly,
2. the manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours,
3. the diversity of products and the diversity in customers' demands have grown, and

4. some products are produced in large batches, while others are produced in small batches.

There are three major differences between ABC and traditional cost accounting methods:
1. In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.
2. Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.
3. Traditional cost accounting is structure-oriented whereas ABC is process-oriented.

Uses of ABC
• It helps to identify inefficient products, departments and activities.
• It helps to allocate more resources on profitable products, departments and activities.
• It helps to control the costs at an individual level and on a departmental level.
• It helps to find unnecessary costs.
• It helps fixing price of product or service scientifically.