Activity-based costing

What it means

Activity-based costing, or ABC, is a method that assigns overheads to products, services and customers according to how many activities they actually consume. Instead of a single markup on direct costs, overhead is allocated through activities such as processing an order, setting up a machine or serving a customer.

Traditional costing spreads overheads by, say, hours worked or direct materials. But if a small order needs as much administration as a large one, the traditional method assigns it too little cost and the large order too much. The result is prices that subsidise unprofitable customers.

The method has three steps: identify the main activities and their costs, find for each a driver that causes it, such as the number of invoices, deliveries or complaints, and assign costs to products and customers according to how much of each driver they use.

How it works in practice

In practice we do not apply ABC to the whole company at once. We start with a question management cares about, such as whether small customers pay, whether the online shop beats wholesale, or why one product line has a thin margin. Analysing a handful of main activities is often enough.

The inputs are accounting data, ideally broken down by cost centre, and operational data such as numbers of orders, invoices and support hours. Where these are missing, a sensible estimate from the people doing the work is fine to start with.

The results often show up in the contribution margin by customer. The company can then adjust its price list, set a minimum order, charge for small deliveries or move small customers to a self-service channel.

What to watch out for

The most common mistake is excessive detail. A model with dozens of activities and drivers cannot be maintained and nobody trusts it. Five to ten main activities usually explain most of the differences in profitability.

The second risk is making decisions on the costing alone. A customer who looks unprofitable may bring in others or be strategically important. ABC is a basis for negotiating and changing terms, not an automatic instruction to end the relationship.