What is Activity-Based Costing (ABC)?

Activity-Based Costing is a methodology that measures the cost and performance of cost objects, activities and resources.

Activity-Based Management is a discipline focusing on the management of activities within business processes as the route to continuously improve both the value received by customers and the profit earned in providing that value. ABM uses Activity-Based Cost information and performance measurements to influence management action.

Cost objects consume activities and activities to consume resources. Resource costs are assigned to activities based on their use of those resources, and activity costs are reassigned to cost objects (outputs) based on the cost objects proportional use of those activities. ABC incorporates causal relationships between cost objects and activities and between activities and resources.

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How ABC improves the accounting process?

There are three primary factors that ABC applies to your organisation to enhance the costing process.

1. Firstly, the number of cost pools is expanded in preparation for assembling overhead costs. To do this, costs are assorted by the activity which they are funding rather than a company-wide effort.
2. ABC also introduces new ways of allocating costs based on the activities which are generating them, rather than only volume measures. For example, machine hours and direct labour costs.
3. Finally, ABC traces costs that are often considered indirect (depreciation, power) to their source.

Limitations of Activity-Based Costing:

The obvious shortcoming of ABC is that it’s an investment in your time and resources to capture data. But, there isn’t any guarantee that with the data you capture you will find significant issues in your costing. Or at least, not significant enough issues to warrant the investment.

Another issue with ABC is that it always treats costs as if they were variable. Therefore, inaccuracies will appear when working with fixed costs. This inaccuracy will lead to incorrect conclusions and wrong decisions.

Further resources of Activity-Based Costing:

• Business Process Management Common Body of Knowledge (BPM CBOK, 2009), The Association of Business Process Management Professionals
• Institute of Management Accountants – Implementing ABC

Related Links:

• Pareto Priority Index
• Complaint Handling Processes at SAPA Group
• Complaint Handling: Customers’ first impressions

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Explore more about different process improvement terms in our BPM Glossary.