Activity Based Costing (ABC)
Activity Based Costing (ABC)
(K. Rowland Atiase)
Activity Based Costing (ABC)
I. Introduction
II. ABC Overview
III. Motivation for ABC (& ABM)
IV. Goals of ABC
V. Steps in ABC
VI. How Many Cost Drivers Should Be Used?
VII. Factors Relevant for Cost Driver Selection
VIII. Traditional versus ABC Systems
IX. ABC & Business Process Analysis (BPA)
X. ABC, Product (Service) Line Profitability & Customer Costing (CC) System
Activity Based Costing (ABC)
I. Introduction
Activity-Based Costing (ABC) has received tremendous attention lately in the business press, in the academic literature, and in industry seminars. Much of the attention has focused on the process of calculating more accurate object (e.g., product) costs. Here, we would adopt a much broader view of the usefulness of ABC beyond product cost determination.
In Traditional Costing Systems (TCS), the cost of Cost Objects (e.g., products, services, customers, etc.) are made of (1) the direct cost traced to the cost objects and (2) the indirect (i.e., overhead) costs applied (allocated) to cost objects. OH costs are usually applied to cost objects (e.g., products, etc.) on the basis of some uniform application base (e.g., DL Hrs or some other volume-based measure).
Peanut-Butter Costing:
The uniform application of costs discussed so far can result in a costing approach that uniformly assigns the cost of resources to cost objects (e.g., products, services, or customers) when the individual cost objects, in fact, use those resources in a non-uniform way. This is called Peanut-butter costing.
Undercosting and Overcosting
The use of peanut-butter costing can lead to under(over) costing of products (services, customers, etc.). Product under(over) costing occurs when a product consumes a relatively high (low) level of resources but is reported to have a relatively low (high) cost. Typically traditional costing system tend to “overcost” (intensely competitive) high volume cost objects.
Why?
By loading too much OH costs on high-volume cost objects.
Product-Cost Cross-Subsidization
Product-cost cross-subsidization occurs when at least one miscosted product results in the miscosting of other products in the organization. A classic example occurs due to peanut-butter costing.
Refinements in costing systems are aimed at addressing problems of product under(over) costing due to peanut-butter costing. This can be achieved in a number of ways.
(a) Refinements via increased direct cost tracing.
(b) Refinements via increased number of indirect cost pools and cost drivers.
(c) Both (a) and (b) above.
II. Activity Based Costing (ABC) - Overview
ABC was first called “Transaction-Based Costing” and then “Strategic Product Costing,” and Ultimately settled on ABC.
Activity based costing (ABC) focuses on ACTIVITIES as the fundamental cost objects. This is the distinct feature of ABC. It uses the cost of these activities as the basis for assigning costs to other cost objects. (e.g., products, services, or customers)

ABC is consistent with either job order or process costing.
III. Motivation for ABC
The motivation for ABC stems from the following concepts:
(i) Activities consume resources of an organization.
(ii) Cost Objects (of products, services, customers, etc.) consume those activities.
(iii) Countable (?) events or Cost Drivers can be used to measure the quantity of resources consumed by a cost object.
(iv) In this way, cost objects (products, etc.) can the begin to reflect the multiple variables that determine their costs.
(v) Costs can also be expanded to include components historically treated as largely OH and spread (i.e., applied) to all cost objectives (i.e., products, services, etc.) regardless of the benefit received.
(vi) Understanding Cost Drivers and Activities Consumed by a cost objects provide management with a powerful process optimization tool.
Example: Consider two firms each producing 1,000,000 articles of clothing each