What is ABC Costing – Activity-based Costing?

What is ABC Costing?

Activity-Based Costing is a method of calculating costs in accounting, which provides a separate analysis by the different activities of the company.

This costing method is also called ABC Costing, in English Activity Based Costing, and offers users of accounting information a performance evaluation for each stage that is to be analyzed.

The purpose of this method is to highlight the higher costs in each activity so that an improvement intervention can be made in these stages.

ABC costing method concept

This methodology for calculating costs began to develop, mainly after the appearance of automated industrial processes. As a result, there was an increase in indirect costs, such as electricity.

Thus, the apportionment of costs by this method allows to identify, among a diversified quantity of products, those that absorb more costs in production.

The central idea of ​​this method is to consider that it is not the products and services that consume the resources, but that the resources are consumed by the activities, in which the final product results.

The purpose of this costing system, for managers and administrators, is to improve the company’s competitiveness by reducing product prices after a cost reduction.

How the cost is calculated using the ABC method

The main feature of this method is the identification of indirect costs, which are only indicated by the aggregate set of activities, but this time, assigned separately for each activity.

In addition, there must be an ordering of those activities that consume most of the resources, which does not appear in other costing methods and that requires greater care when doing it.

This ordering is defined taking into account the activities to be analyzed separately, by product, production line, services or whatever is necessary.

Targeting resource costs

ABC considers activities as the main users of resources, so the first step is to analyze how they consume the resources used, from a “driver” of these costs.

With this direction, the factor to be analyzed must be determined, such as: considering a certain stage of production, how much electricity is consumed in that activity.

Targeting activity costs

The second step is to identify how much the products or services consume from the activities, in order to obtain the final result.

This direction arises from the previous step, now considering the factors that lead to the consumption of the activity, such as: to produce a certain product, how much was spent on workers by sector.

Example of using this method

Each resource used is directed to one or more activities, such as the use of a forklift to store materials in stock, but also to board the goods in dispatch.

The two activities mentioned, may still have other resources in common, such as labor and administrative personnel who take them, end up defining the product or service ready for sale. In this case, it is possible to analyze the cost of each product as a cost object.

Advantages and disadvantages of ABC Costing

As advantages of this cost tracking system we can consider:

  • Better quality of information on production costs or services;
  • It can be used as a management accounting system;
  • Less need for arbitrary apportionments;
  • Identifies which products or services consume the most resources and their consequent expenses;
  • Identify the cost of each activity by the total costs.

This costing system also has its limitations when deciding to implement, of which we can list:

  • It is a complex costing method and it takes time to fully calculate it;
  • It is necessary to formulate the analysis standards themselves, which requires a lot of dedication on the part of the team;
  • The information sought may not be entirely reliable;
  • It needs constant review.