What is activity based costing?

It is a method of allocating indirect costs to products.
For example, say you make widgets and gizmos in the same plant.
You may have good direct-cost data for the inputs (plastic, machine depreciation).
What about the plant manager? If she spends 90% of her time working on widgets, 1% on gizmos, 5% on general plant, and 4% on admin....that lets you assign the proper amount of her cost to the widgets and gizmos that you make.

As opposed to fixed and direct costs; ABC identifies a cost that is variable like a direct cost, but is not aggregated to a particular target product. If your widgets have 2 ounces of platinum each, that's easy to compute. But, how much electricity does widget consumption consume vs. the gizmos in the same plant? The goal is to charge the products appropriately with the amount of cost they consume.

This can be extended outside of the plant, and include selling, returns, etc., to determine gross and net contribution margin per product line.

Criticisms include the cost of capturing that detail accurately, both the direct cost impact and the impact on the process itself when measuring the cost.

Interestingly this was a hot topic back in the early 1990's and it was 45% of the final management accounting course in the Canadian CMA program. Since then, I have rarely seen this mentioned in job ads as a requirement as Keith points out, all the tracking and time-sheets proved not to be cost-effective and accepted.

Rafiqul, Keith, Gil and others ... A reason that many have the misconception that ABC does not work is in large part due to a "black eye" ABC received from ABC implementations in the 1990s created over-engineered ABC models that were well beyond diminishing returns of extra accuracy for the incremental administrative effort to collect, validate, and report the information. Other causes were misunderstandings that accuracy derived from employee time sheets and that every activity driver had to be imported from an ERP system or some other data source.

Successful implementations came from the ABC "rapid prototyping with iterative remodeling" to quickly get to a "right-sized" permanent repeatable production ABC system. Eventually where ABC applies it will be commonly accepted.

An increasing need for ABC is to measure and manage customer profitability. This is described in this article I recently authored:

http://www.industryweek.com/finance/why-measure-channel-and-customer-profitability

Gary ... Gary Cokins