Activity Based Costing

Term Definition
Activity Based Costing (ABC system) is a costing methodology where costs are allocated to products and services based on the number of transactions or events involved in the process of providing the product or service.

The concept of Activity Based Costing was developed in the manufacturing sector and given a broader audience by Robin Cooper and Robert Kaplan. Cooper and Kaplan, proponents of the Balance Scorecard, published a number of articles in Harvard Business Review beginning in 1988. Cooper and Kaplan presented Activity Based Costing as an approach to solve the problems of traditional cost management systems. Traditional cost accounting was limited in its ability to accurately determine the costs of production and related services. As such, managers made decisions based on inaccurate data. Activity based costing by contrast identifies cause and effect relationships in order to objectively assign costs. Once activity costs are identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. Activity based costing enables managers in this way to identify and correct areas of high overhead costs per unit.

Activity based costing can provide detailed cost information to support annual budgets, and determine customer profitability. It also enables management to see how performance can be maximized and growth strategies realized. For example, a customer may appear to be profitable based on income. However, in applying activity based costing, where costs are associated with the services that the customer demands, it may be discovered that the “profitable” customer is driving the largest expenses. In identifying cost drivers, it is important to ensure that the activities are measurable and relevant. You must be able to determine that the activity has a direct or indirect relationship to the cost of doing business and you must be able to allocate to each customer the portion attributable to the activities consumed.

Area of Application
Project Accounting

Related Terms
Cost Accounting

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