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Activity Based Costing Vs Traditional Steps, Results Compared

September 15, 2023
Bill Kimball

Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The cost driver is a factor that creates or drives the cost of the activity.

abc method

The ABC system assigns costs to each activity that goes into production, such as workers testing a product. Even in ABC, some overhead costs are difficult to assign to products and customers, such as the chief executive’s salary. These costs are termed ‘business sustaining’ and are not assigned to products and customers because there is no meaningful method.

Such expansion has caused ABC systems to exceed the capacity of generic spreadsheet tools, such as Microsoft Excel, and even many ABC software packages. The systems could take days to process one month’s worth of data. For example, the automated ABC model for Hendee Enterprises, a $12 million fabricator of awnings, took three days to calculate costs for its 40 departments, 150 activities, 10,000 orders, and 45,000 line items. Activity-based costing was later explained in 1999 by Peter F. Drucker in the book Management Challenges of the 21st Century.

Adoption Of Abc And Abm

Manufacturing firms do not set up production machines for each product unit. They are set up instead for the production run of each product model. Direct materials costs might include costs per product unit for metal stock, fasteners, and lubricants. When it comes tosupply chain and warehouse management,ABC inventory analysis is majorly used for the stock count cycles.

And, the table also shows the conventional costing solutions for gross profit and gross margin for each product unit. For this example, the firm’s accountants chose to allocate indirect costs referring to direct labor costs. ABC pursues these objectives primarily by making direct costs out of many of the expenses that traditional cost accounting treats as indirect costs. He desire to improve costing accuracy moves business people to adopt ABC, mainly to get closer to the true cost and true profitability of individual products and services. They move to Activity Based costing for the same reasons to understand better the true costs and return on investment from projects, programs, or other initiatives. Activity-based costing is more complicated than traditional costing.

The sales figures alone can be very misleading when it comes to analyzing your customers. Seeing a customer who makes a purchase once or twice a week for a small amount can certainly goof you up into thinking that they are valuable when they are actually not. Instead of the sales figures, drive your perspective more towards the actionable data. This will enable you to take actual decisions that will boost your revenue. The rest of the customers are automatically included inCategory C. Here, the customers are the ones which turn up once in a while and make a purchase.

ABC contrasts with traditional costing , which sometimes assigns costs using somewhat arbitrary allocation percentages for overhead or the so-called indirect costs. As a result, ABC and traditional cost accounting can estimate the cost of goods sold and gross margin very differently for individual products. Contradictory and uncertain cost estimates can be a problem when management needs to know precisely which products are profitable and which are selling at a loss. Direct costs are the same under both traditional costing and ABC. For direct costs, accountants measure a product unit cost for each direct cost category.

For more information about benefits and best practices, check out our inventory management guide. However, analysis shows that valuable things do tend to bend toward an 80/20 distribution. ABC analysis identifies the “sweet spot” where most of a business’s revenue comes from with relatively little effort. Fewer stock outs and improved production efficiency resulting in more reliable cycle time and, therefore, improved customer satisfaction.

abc method

This lump of unallocated overhead costs must nevertheless be met by contributions from each of the products, but it is not as large as the overhead costs before ABC is employed. Several factors can affect a product’s value or importance – item cost, quantity sold, and margin set. There is no need for unnecessarily crowding your warehouse with the product that has a low margin and is also not sold frequently. In such cases, the ABC inventory system analysis lets the planners set service levels based on the product classification. This further makes the supply chain smoother, carrying no additional safety stocks. Banta’s time-driven ABC system, which was fully implemented within 16 weeks, revealed much more granularity in its expense structure by tying costs to products, orders, customers, and territories.

Once again, precision is not critical; rough accuracy is sufficient. In the case of our example, let’s suppose that managers determine that it takes 8 minutes to process an order, 44 minutes to handle an inquiry, and 50 minutes to perform a credit check. The potential problem with ABC, like other cost allocation approaches, is that it essentially treats fixed costs as if they were variable. This can, without proper understanding, give some people an inaccurate understanding which can then lead to poor decision making.

Financial Metrics are center-stage in every business, every day. Metrics are crucial for business planning, making informed decisions, defining strategic targets, and measuring performance. Essentials for mastering the case-building process and delivering results that win approval, funding, and top-level support. The article Cost Object defines and explains the term “cost object.” Shipping ManagementGet to know A-to-Z about shipping including its types, important terms, and costs. #2 Collect the data from your inventory that has been analyzed. Let’s walk through a scenario that we’ve experienced many times in working with our clients.

How Abc Analysis Simplifies Work For Inventory Managers

Lisa, in search for varieties and additions to her sweater inventory, has filled in 180 types of sweaters instead of just 50 types. She now realizes that this business is seasonal, and she has already invested a lot. As a purchasing manager, understanding your sales over a certain period will help you evaluate and segregate which product belongs in which category i.e., A, B, or C. This will also assist the purchase manager in analyzing what to buy, and in what quantity. The ABC concept can also be applied to the cycle counting of inventory, where “A” items are counted much more frequently than “B” and “C” items. The justification for doing so is that the higher transaction volume of “A” items is more likely to trigger inventory recordation errors. The proportions indicated above for the ABC method are approximate, and will vary somewhat based on actual experience.

abc method

But, some production-related activities use more overhead expenses than others. As a result, traditional costing can give an inaccurate cost of making each product.

Step 4 Identify Indirect Activity Pools, Cost Drivers, Unit Costs

One product may consume relatively more maintenance resources, for instance, while another product may consume relatively fewer maintenance resources, but relatively more for machine set up. Activity Based costing requires detailed knowledge of the activities and resources that go into overhead (or “indirect”) support work. ABC analysis recognizes that product A uses more activity pool resources than product B.

  • From the given cost of each CD unit, calculate the total cost for each activity pool, for each product.
  • In addition, the order may be entered into the system either manually or electronically, and it may be either a standard or an expedited transaction.
  • It then assigns the cost of those activities only to the products that are actually demanding the activities.
  • Inventory optimization is the most crucial reason why ABC inventory analysis is preferred by many businesses.
  • For example, Christmas sweaters are mostly sold during the season and not very much before or after that.

If this company used traditional costing, it might allocate or “spread” all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product 124, because it did not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an enormous amount of overhead , but it demanded little overhead activity. The result will be a miscalculation of each product’s true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine. However, as the percentages of indirect or overhead costs rose, this technique became increasingly inaccurate, because indirect costs were not caused equally by all products.

Instead of general overhead costs and production-related activities, you need to be specific. Not sure what activities your overhead costs are going towards? With activity-based costing, product-focused businesses can get into the nitty-gritty details to better allocate expenses. That means you can more accurately analyze your spending—and price your products.

Introduction To Activity Based Costing

These order- and transaction-specific data enable the particular time demands for any given order to be quickly determined using a calculation like the one above. The key insight is that although transactions can easily become complicated, managers can usually identify what makes them complicated. The variables that affect most such activities can often be precisely specified and are typically already recorded in a company’s information systems. To take an example, let’s assume a manager is looking at the process of packaging a chemical for shipment. In this situation, complexity arises from the potential need for special packaging and the additional demands of air as opposed to ground transportation. The state of the art approach with authentication and authorization in IETF standard RADIUS gives an easy solution for accounting all workposition based activities. That simply defines the extension of the Authentication and Authorization concept to a more advanced AA and Accounting concept.

Transition To Automated Activity

Of course, you then have to add back in the cost impact of purchasing the new database system by updating the cost per time unit estimate, so the final figure may be somewhat higher than $16. Let’s say employees report that they spend about 70% of their time on customer orders, 10% on inquiries or complaints, and 20% on credit checks. Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently, managers were making decisions based on inaccurate data especially where there are multiple products. Their consumption values are lower than A items but higher than C items.


ABC analysis, despite all its benefits for inventory maintenance and management, is not a one-size-fits-all inventory management solution. Every organization has specific customer demand patterns, classifications, systems and other issues that affect the usefulness of an ABC analysis.

Industrial Application Of Abc Analysis

Inventory ManagementLearn the essentials of inventory management in this collection of guides. Before you begin to analyze, collect some data that is already available through any accounting tool, related to the annual spending. This can include all the ordering costs, carrying costs, etc. if at all, they are readily available. Category C– This category includes the products that are neither in category A nor category B.

The model lets you answer “What If?” questions, easily and it is indispensable for professional risk analysis. Modeling Pro is an Excel-based app with a complete model-building tutorial and live templates for your own models. Organizations can anticipate overhead costs and funding needs with greater accuracy and more certainty under ABC. Complete details on activities that go into specific products, services, and tasks.

The objective is to be approximately right, say within 5% to 10% of the actual number, rather than precise. If the estimate of practical capacity is grossly in error, the process of running the time-driven ABC system will reveal the error over time. His section presents an ABC version of the same product costing situation presented above as Traditional Costing. The examples show how ABC and traditional costing can yield different indirect cost estimates for the same products.