Why Activity Based Costing

Activity Based Costing - ABC Costing Approach is a management accounting method that has helped many companies improve their profitability and cost structure. ABC costing identifies opportunities for management to improve pricing, products, services, operations and key business processes in order to improve competitiveness. Activity-Based Costing is used for making better business decisions. Indirect Costs are not easily traceable to cost objects. Cost elements are shared among cost objects and are physically impossible to trace and it is not cost effective to trace. The purpose of allocating indirect costs in ABC is estimating total costs (direct + indirect costs) associated with a product, service, activity and customer. By doing that decision makers develop better understanding of indirect costs beceause business activities are not free. Activity based costing allows managers to plan and manage more efficient business operations.

Traditionaly indirect costs are allocated to cost object based on the cost object’s consumption of some measure of activity - usually labor hours. However this approach assumes all overhead is volume related so allocation is based on companywide or departmental rates (this is departmental focus versus busoiness process focus driven by activities). Traditionallu cost allocation is based on costs incurred of cause of the costs. Cost allocation with activity based costing methos is based on causal activities - identifying relationships between costs and cost objects which results in better cost allocation. ABC identifies activities required to produce a product or service, determines the cost of the activities associated by the product or service, allocates costs to cost objects based on the object’s consumption of activities. Compared to traditional accounting, Activity Based Costing reports accurate product and service costs and provides insight into the cost drivers and identifies value added and non value added activities providing opportunities for improvements on geneal company level as well as product and customer level.