The activity-based costing method (ABC) was developed in the 1980s when companies were seeking more accurate methods to allocate indirect costs to products and services. This approach emerged in response to the limitations of traditional cost accounting systems, which often allocated indirect costs too generally, leading to inefficient management decisions.
The ABC method was popularized by Robert S. Kaplan and Robin Cooper of Harvard Business School. Their goal was to create a system that more accurately reflects the actual consumption of resources by various activities within companies. By assigning costs more precisely to activities, this method allows companies to better understand how resources are used and make more informed decisions.
World-renowned companies have adopted the ABC method to optimize their processes and improve profitability. For example, Procter & Gamble used this method to streamline its production operations and better understand the costs associated with manufacturing its products. Similarly, Boeing applied it to manage the costs of its aircraft development programs, enabling more precise resource management and better strategic planning.
Resources are all the elements necessary to carry out a company's activities.
This includes, for example:
Activities represent the various tasks or processes carried out within the company to produce goods or provide services.
Here are some examples:
Products are the final result of the company's activities, which can be tangible goods or services.
Here are some examples:
These three levels are interconnected in the ABC method. Resources are used to perform activities, which in turn contribute to the creation of products. This approach allows for a precise understanding of how resources are consumed by activities and how these activities influence the total cost of final products.
Here are the key steps to apply this method, while incorporating the three fundamental concepts: resources, activities, and products.
The first step is to determine all the activities necessary for the production of goods or the provision of services, as well as the resources associated with them. Resources can include salaries, materials, energy, etc. Activities include actions such as assembly, packaging, machine maintenance, order processing, etc.
Once activities and resources are identified, direct costs (such as salaries, materials, etc.) and indirect costs (such as electricity, rent, etc.) are assigned to them. This allows for the allocation of financial resources to various activities. Resource costs are distributed based on their consumption by each activity.
Cost drivers influence the level of activity costs. For example, the number of labor hours, units produced, or production orders can be cost drivers. Choosing these drivers correctly is crucial as they impact the accuracy of allocated costs.
Once activity costs and cost drivers are determined, activity rates are calculated. This is done by dividing the total cost of each activity by the total number of cost drivers. For example, if the total cost of an activity is 1000 euros and the number of labor hours is 50, the activity rate will be 20 euros per labor hour.
Finally, activity costs are assigned to products or services using activity rates and cost drivers. This provides a more accurate picture of the costs of producing goods or providing services. For example, if a product uses 10 labor hours, the cost allocated to this product for this activity will be 200 euros (10 hours x 20 euros/hour).
By applying the ABC method, organizations understand and control their costs, leading to more informed decision-making and improved profitability. This method is particularly useful in complex environments where products and services require various activities and where indirect costs are significant.
Special Case
For IT department costs, a specific ABC model for IT costs is proposed by Cigref: if you want to know more, check out our article on Cigref's ABC model for IT departments.
