ABC Costing is a supplemental method of cost accounting that provides the decision-making information absent from traditional costing methods. While ABC costing is not limited by business unit boundaries, it can not fully supplant traditional costing methods as it often fails to meet financial reporting requirements for businesses.
ABC Costing focuses on costs contributing to production of a product. It does not attribute other general costs that do not have at least an indirect relationship to the product. While traditional costing systems focus on direct costs and burden a product with other fixed costs, activity based costing increases accuracy of indirect cost assignment.
In their 1999 book, Managerial Accounting, Garrison and Noreen identify six core steps to ABC costing implementation.*
First, activities must be identified and grouped together in activity pools. Activity pools are the supporting activities that tie in to a product line or service These pools or buckets may include fractionally assigned costs of supporting activities to individual products as appropriate during the second step.
ABC continues with activity analysis, clearly identifying the processes which support a product and avoiding some of the systemic inaccuracies of traditional costing. ABC costing requires activity analysis, similar to the process mapping found in lean manufacturing.
This activity analysis identifies indirect cost relationships and allows assignment of some percentage of that activity to an end product directly.
Based on the findings of step #1 and #2, costs are assigned to an activity pool. For example, human resources costs would be assigned to indirect administrative or indirect management costs. These pools will each have some contribution to object cost.
Initial analysis may include direct labor hours, or indirect support labor. These activities must be assigned a value in real currency. All weightings must be added at this step. For instance, production labor hours should be in terms of a weighted labor rate including benefit costs.
Once activity costs, pools and rates are identified and clearly defined, the next step is to assign them to cost objects. Objects are generally defined as the results offered to a customer. In both manufacturing and non-manufacturing environments, this product should have some saleable value to compare to the assigned costs.
Once ABC costing analysis is complete, that cost data should be placed in a concise and coherent manner for cost object and process owners. This communication of the costing analysis is critical to justify the cost of the analysis, as often this is not an inconsequential cost.
ABC costing does nothing for the organization if the information is collected but no action follows. The key to the value of this form of costing is that it is actionable. This analysis allows companies to make decisions about product lines, where to direct sales efforts, and to validate the true value provided by capital equipment.
*Garrison, Ray H., and Eric W. Noreen. Managerial Accounting. 9th ed. Boston: Irwin McGraw-Hill, 1999.