Knowing Your ABC - Using Activity Based Costing To Analyse Your Business


Say you own a small manufacturing firm. You produce two technically sound products, Product A and Product B, which you deliver on time. Your customers are happy, your productivity lies above industry average and your company has grown substantially in the first few years after you founded it. Great scenario, isn’t it?

However, there is one problem - your profitability has been at a very low level for quite some time now. You have sought reasonable explanations. Maybe you don’t sell enough products to be profitable and the world economy is in a slump, which is affecting your business. You should just try and sell more products, right?

Not necessarily! The reality is that an increase in your sales does not always mean that your profit will go up as well. In fact, one of the products you manufacture may be a money maker, while the other may be a money loser. As your profit is suffering, you may be producing too many money losers. You thus have to find out where exactly you are making and losing money, i.e., you have to determine the true cost of each product.

So how you do gain a good understanding of the contribution that each product makes to your overall profitability? Through a costing model named Activity Based Costing (ABC).

What is Activity Based Costing?

Activity Based Costing is used to identify, describe, assign costs to, and report on your business operations. ABC helps you identify opportunities to improve the effectiveness and efficiency of your business processes by determining the true cost of your products or service.

The basic premise of ABC is that cost objects (products, services) consume activities. These activities in turn consume resources and these resources drive costs. ABC thus focuses on work rather than workers.

ABC determines which activities add value to your business, i.e., which activities will best accomplish a mission, deliver a service, or meet customer demand. ABC allows you to measure the costs of each activity and compare those costs against the importance of that activity in your business. It identifies where the real cost drivers in your business are and it shows where you are using resources most effectively, and more importantly, least effectively.

How does ABC work?

Going back to the example of the small manufacturer, if you decided to apply ABC to your business you would first examine all the steps involved in producing product A and product B (these steps could include using and maintaining machines, receiving supplies etc), after which you determine the costs involved with these steps. These costs include tangible and intangible costs. Tangible costs are costs such as equipment, computer hardware, which are quite easy to measure. Intangible costs, however, can be hard to measure and include productivity loss, employee absenteeism, and corporate overhead and management time for example.

The next step is to gather information on the activities that are connected to the steps involved in producing product A and product B, but which you wouldn’t readily associate with those steps. For example, when you receive supplies somebody has placed an order for these supplies. When they order supplies, how long does it take them? And do your sales reps spend a lot of time on the phone talking to your customers about product A? You are likely to take these activities for granted, while in fact they can cost you a considerable amount of money.

Once you have sufficient information on these cost drivers, you need to analyse them to see where you are spending the most money and whether this money is being spent with reason. You can now rate the costs of activities in your business against their importance and determine if there are steps that you can modernise or get rid of completely. For example, would it be more cost efficient to order supplies online rather than by filling out a form which has to be faxed to your supplier?

Would ABC work for your business?

Before you embark on a mission to change to ABC, you must realise that implementing ABC will require a considerable investment in time and money. You will have to change the organisation of your business, prepare your team members and get them to accept the change, and invest in computer hardware and software.

However, ABC could be particularly useful to you if:

-  You have high overheads
-  You produce diverse products or services
-  The cost of errors is high, and/or
-  Competition is tough.

Until next week,
Mike Reddy