What is ABC?

- Let's imagine that you're running a business and you have set prices for a range of different services that your organization provides. But what you really want to know is what is the full cost of providing these services? And how can I better control these costs? Well if you've ever stopped to ask yourself these questions, well then, guess what? You have pretty much uncovered the basics of activity-based costing. Activity-based costing, or simply ABC, is a cost accounting method that assigns a business's overhead costs to the products and services that rely on them. For example, instead of just knowing the direct costs to produce toys in a factory, that is things like the materials used and the staff employed to assemble the toys, you take the time to understand the factory's overheads. We're talking here about things like utilities, the cost of running machinery, etc. And you then distribute those costs to provide a more complete picture. You may be wondering why all this matters. Well, when used correctly, ABC can help managers, and indeed thought leaders, make key business decisions on things like the supply chain, proactive service viability, and even where to allocate marketing dollars. You might also be wondering about the evolution of ABC. Well, even if you're not, I'm going to regale you with a little bit of history. ABC emerged back in the seventies, following the collapse of the post-war expansion. Prior to this period of time, businesses, particularly in the manufacturing sector, pretty much couldn't fail. So there wasn't much of an appetite to closely monitor expenditure. However, after the collapse, the risk of business failure suddenly became much higher. They needed a new way of tracking the full cost of production. Enter ABC. The problem here was because the concepts of ABC were so new it's application was rather ad hoc and yielded very limited benefits. In actual fact, many businesses simply gave up using ABC. But by the eighties, ABC started to gain more traction. And the principles became more formalized in a kind of cost accounting method. ABC is still widely used today. And with the increased availability of data, its potential uses are even more powerful than ever before. How is ABC different to traditional accounting? Well, in conventional costing processes, direct costs and indirect costs are generally kept separate. Let's take a look at an example. Here are the same inputs of the same business, but presented in two different ways. In view one, the overheads of the business are kept separate from direct costs. And this gives a rather misleading picture of the full cost of producing these products. While financial accountants love this, it doesn't really provide any value aside from making budgeting easier. Any attempt to fully allocate costs to products and services using this information is going to be arbitrary and inaccurate. View two however, uses ABC. And as you can see, the total costs are exactly the same as view one, but the overheads have been allocated using something called cost drivers. And this gives a more accurate and complete view of the business's product cost. ABC gives you access to the inherent drivers of indirect costs, that is overheads. This allows organizations to make more conscious business decisions that can ultimately improve profitability.