What it means
Traditional costing was designed for factories where direct labour and materials were most of the cost and overhead was small. It allocates overhead with one or two blanket rates, such as a percentage of direct labour cost.
As businesses automated and overhead grew to dominate, that approach began to distort. A high-volume, simple product and a low-volume, complex product might use the same labour hours, so they receive the same overhead, yet the complex product causes far more set-ups, engineering changes, quality checks and customer calls.
Traditional costing overcharges the simple product and undercharges the complex one, and businesses that price on those costs lose money on the products they think are their best. ABC corrects this in four steps.
First, identify the significant activities that consume overhead. Second, assign the overhead costs to those activities, creating cost pools: the cost of running the purchasing department, the cost of machine set-ups, the cost of the quality lab.
Third, identify a cost driver for each pool, the measure of activity that best explains its cost: number of purchase orders, number of set-ups, number of inspections. Fourth, calculate a rate per driver unit and charge each product for the driver units it consumes.
The insights are often dramatic. Products that seemed marginally profitable turn out to be heavily loss-making once the cost of their complexity is attached to them; large customers who demand special handling, small orders and frequent changes turn out to cost more to serve than they contribute.
Businesses use ABC to reprice, to rationalise ranges, to redesign products for lower complexity and to charge customers for the services they consume. ABC is expensive to set up and maintain, which is why many businesses run it as a periodic study rather than a live system, and why a simplified variant, time-driven ABC, which estimates the cost per minute of each department's capacity and the minutes each activity takes, has become popular.
The underlying principle, that costs should follow causes, is the point; the level of precision is a choice.
In practice
Real-world examples.
Example
A bank uses ABC to discover that customers with small balances who visit branches frequently cost three times more to serve than the fees they pay, and redesigns its account tiers.
Example
A hospital applies time-driven ABC to a knee replacement pathway and finds that the most expensive step is not surgery but the days of ward time consumed by delayed discharges.
Example
A food manufacturer finds through ABC that its 40 smallest product lines, 5% of revenue, consume 30% of set-up and changeover costs, and discontinues 25 of them.
Think of it
“ABC assigns costs based on what activities products actually require-more accurate than spreading costs evenly.
Formula
Calculation
Activity Rate = Total Cost of Activity Pool / Total Units of Cost Driver
Overhead assigned to a product = Sum over activities of (Activity Rate x Driver units consumed by the product)
Worked example. A manufacturer makes two products with total annual overhead of $600,000. Traditional costing spreads overhead by machine hours: Product A uses 8,000 hours and Product B 2,000 hours, so A receives $480,000 and B $120,000.
Under ABC, the overhead is analysed into three pools:
- Machine running costs: $300,000, driven by machine hours (10,000 total): rate $30 per hour
- Set-up costs: $200,000, driven by number of set-ups (A needs 20 set-ups, B needs 180; 200 total): rate $1,000 per set-up
- Order processing: $100,000, driven by customer orders (A has 400 orders, B has 1,600; 2,000 total): rate $50 per order
Overhead assigned under ABC:
- Product A: 8,000 x $30 + 20 x $1,000 + 400 x $50 = $240,000 + $20,000 + $20,000 = $280,000
- Product B: 2,000 x $30 + 180 x $1,000 + 1,600 x $50 = $60,000 + $180,000 + $80,000 = $320,000
Product B, which traditional costing charged $120,000, actually causes $320,000 of overhead. If B sells 10,000 units a year at $60 with direct costs of $35, traditional costing shows a profit of $10 per unit ($60 minus $35 minus $12 overhead); ABC shows a loss of $7 per unit ($60 minus $35 minus $32). Product A, meanwhile, is $200,000 more profitable than the company thought.Case study
Seen in the real world.
An industrial fasteners distributor with 12,000 stock lines and 3,000 customers priced everything at cost plus a standard 35% and believed its large customers were its most profitable. An ABC study assigned the costs of order handling, picking, packing, delivery, credit control and returns to individual customers using drivers such as number of order lines, number of deliveries and number of returns. The results reversed the company's assumptions.
Its ten largest customers, who ordered daily in small quantities with next-day delivery and frequent returns, cost so much to serve that six of them were loss-making after overhead. Meanwhile, a group of mid-sized customers who ordered monthly in bulk were the true profit engine.
The distributor introduced a minimum order value, a delivery charge below a threshold and a returns fee for non-faulty goods, and moved the small-order customers onto a web ordering platform. Three large customers left; overall profit rose 28% the following year on revenue that fell 4%.
Watch out
Common mistakes.
- Choosing cost drivers that are easy to count rather than ones that actually cause the cost. A driver that does not explain the cost pool produces allocations no better than the traditional method.
- Building an ABC system so detailed that it costs more to run than the decisions it informs are worth. Start with the few activities that consume most overhead.
- Treating ABC figures as precise. They are better estimates than blanket rates, but they are still estimates.
Questions
People also ask.
What is the difference between ABC and traditional costing?
Traditional costing spreads overhead on one broad basis such as labour hours. ABC traces overhead to the activities that cause it and charges products according to the activities they use.
Is ABC used for financial reporting?
Rarely. Statutory accounts usually use simpler absorption methods. ABC is a management tool for pricing, product and customer decisions.
What is time-driven ABC?
A simplified version that estimates the cost per unit of time for each department and the time each activity takes, avoiding the need to survey staff about how they spend their day.
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