How much does your product or service really cost to produce? Activity based costing (ABC) is a proven way to find out. Basically, ABC assigns costs to a product or service based on the actual amount of resources that it consumes. These resources include so-called ‘indirect’ or ‘overhead’ costs such as a manufacturing facility’s light bill or the product’s marketing expenses.

With traditional accounting, overhead is allocated based on a product or service’s ‘direct’ costs, such as raw materials. The problem is, two products that require the same direct costs could vary widely with indirect costs. For example, a customized product may require the same amount of raw materials (direct cost) to produce as a mass-produced one. But the customized product could need far more set-up, testing and maintenance time (an indirect cost). A traditional accounting method would not note the difference, which would create an inaccurate picture of the true cost of both products.

For companies that create a lot of customized products or services, traditional accounting simply falls short. As technology makes ‘mass customization’ more and more feasible, the need for activity-based costing continues to accelerate.

Actiity Based Costing in the real world

Does ABC make a true difference in practice? Ask Chrysler, which claims to have saved hundreds of millions of dollars by making the switch to ABC in the early 1990s. With it, Chrysler learned that certain parts cost 30 times more than estimated via traditional accounting. Needless to say, Chrysler started to outsource many of those parts.

The momentum for activity-based cost continues to grow, due to a number of paradigm shifts:

  • Overhead costs continue to grow in both the manufacturing and service sectors.
  • There’s a growing need for more and more product and service customization, as customers and their individual needs become more diverse.
  • Even the quantities of many products are becoming more variable, with some being produced in ever-larger batches while others are created in smaller, more specialized ones to serve niche markets.

Is an activity-based costing system (ABC) a better way for your organization to understand its true costs? Email us here to learn more.