Activity-based costing (ABC) is a costing model that assigns indirect costs to products based on actual consumption, enabling organizations to identify unprofitable products and make informed pricing decisions. Developed from traditional costing methods in the 1970s and 1980s, ABC focuses on cost drivers to improve accuracy in cost allocation and has applications beyond manufacturing, including financial institutions. Despite its utility, ABC can be complex and costly, leading to the emergence of lean accounting methods that seek to streamline cost control.

1. Activity-based costing A Case study
Activity-based costing (ABC) is a costing model that identifies
activities in an organization and assigns the cost of each
activity resource to all products and services according to the
actual consumption by each: it assigns more indirect costs
(overhead) into direct costs.
In this way an organization can precisely estimate the cost of
its individual products and services for the purposes of
identifying and eliminating those which are unprofitable and
lowering the prices of those which are overpriced.
In a business organization, the ABC methodology assigns an
organization's resource costs through activities to the
products and services provided to its customers. It is generally
used as a tool for understanding product and customer cost
and profitability. As such, ABC has predominantly been used to
support strategic decisions such as pricing, outsourcing and
identification and measurement of process improvement
initiatives.
Historical development
Traditionally cost accountants had arbitrarily added a broad
percentage of expenses into the indirect cost
However as the percentages of indirect or overhead costs had
risen, this technique became increasingly inaccurate because
the indirect costs were not caused equally by all the products.
For example, one product might take more time in one
expensive machine than another product, but since the amount
of direct labor and materials might be the same, the additional
cost for the use of the machine would not be recognised when
the same broad 'on-cost' percentage is added to all products.
Consequently, when multiple products share common costs,
there is a danger of one product subsidizing another.
The concepts of ABC were developed in the manufacturing
sector of the United States during the 1970s and 1980s. During
this time, the Consortium for Advanced Management-

2. International, now known simply as CAM-I, provided a
formative role for studying and formalizing the principles that
have become more formally known as Activity-Based Costing.
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.
Instead of using broad arbitrary percentages to allocate costs,
ABC seeks to identify cause and effect relationships to
objectively assign costs. Once costs of the activities have been
identified, the cost of each activity is attributed to each product
to the extent that the product uses the activity. In this way ABC
often identifies areas of high overhead costs per unit and so
directs attention to finding ways to reduce the costs or to
charge more for costly products.
Activity-based costing was first clearly defined in 1987 by
Robert S. Kaplan and W. Bruns as a chapter in their book
Accounting and Management: A Field Study Perspective. They initially focused
on manufacturing industry where increasing technology and
productivity improvements have reduced the relative
proportion of the direct costs of labor and materials, but have
increased relative proportion of indirect costs. For example,
increased automation has reduced labor, which is a direct
cost, but has increased depreciation, which is an indirect cost.
Like manufacturing industries, financial institutions also have
diverse products and customers which can cause cross-
product cross-customer subsidies. Since personnel expenses
represent the largest single component of non-interest
expense in financial institutions, these costs must also be
attributed more accurately to products and customers. Activity
based costing, even though originally developed for
manufacturing, may even be a more useful tool for doing this

3. Methodology
• Cost allocation
• Fixed cost
• Variable cost
• Cost driver
• Cost driver rate
Direct labor and materials are relatively easy to trace directly
to products, but it is more difficult to directly allocate indirect
costs to products. Where products use common resources
differently, some sort of weighting is needed in the cost
allocation process. The measure of the use of a shared activity
by each of the products is known as the cost driver. For example,
the cost of the activity of bank tellers can be ascribed to each
product by measuring how long each product's transactions
takes at the counter and then by measuring the number of
each type of transaction.
Uses
• It helps to identify inefficient products, departments and
activities
• It helps to allocate more resources on profitable
products, departments and activities
• It helps to control the costs at an individual level and on a
departmental level
• It helps to find unnecessary costs
The Importance of Activity-Based Costing in a Performance Management
Strategy
Understanding customer and product profitability can mean the
difference between promoting products and services that
generate the greatest returns and wasting time and energy on
a losing proposition. Consequently, as companies look to
leverage their investment in enterprise performance
management (EPM), improved profitability analysis is a
necessary component to complete the picture of an
organization’s performance. With the improved insight EPM
gives into strategic direction and the key performance

4. indicators of every business unit, management’s expectations
for detailed insights are increasing—and the search for the
“Holy Grail” of profitability analysis is intensifying
Cost

5. ABC is considered a relatively costly accounting methodology
Lean accounting methods have been developed in recent
years to provide relevant and thorough accounting, control,
and measurement systems without the complex and highly
wasteful methods of ABC. Lean Accounting takes an opposite
direction from ABC by working to eliminate cost allocations
rather than find complicated methods of allocation.
While lean accounting is primarily used within lean
manufacturing, the approach has proven useful in many other
areas including healthcare, construction, financial services,
governments, and other industries.
Limitations
Even in activity-based costing, 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. 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.
Although some may argue that costs untraceable to activities
should be "arbitrarily allocated" to products, it is important to
realize that the only purpose of ABC is to provide information to

6. management. Therefore, there is no reason to assign any cost
in an arbitrary manner.
ABC analysis
ABC analysis is a business term used to define an inventory
categorization technique often used in materials management.
It is also known as Selective Inventory Control.
ABC analysis provides a mechanism for identifying items which
will have a significant impact on overall inventory cost whilst
also providing a mechanism for identifying different categories
of stock that will require different management and controls
When carrying out an ABC analysis, inventory items are valued
(item cost multiplied by quantity issued/consumed in period)
with the results then ranked. The results are then grouped
typically into three bands. These bands are called ABC
codes.ABC codes
1. "A class" inventory will typically contain items that account
for 80% of total value, or 20% of total items.
2. "B class" inventory will have around 15% of total value, or
30% of total items.
3. "C class" inventory will account for the remaining 5%, or
50% of total items.
ABC Analysis is similar to the Pareto principle in that the "A
class" group will typically account for a large proportion of the
overall value but a small percentage of the overall volume of
inventory.
Another recommended breakdown of ABC classes:
1. "A" approximately 10% of items or 66.6% of value
2. "B" approximately 20% of items or 23.3% of value
3. "C" approximately 70% of items or 10.1% of value
Activity Based Costing
Worked Example

7. The following information provides details of the costs, volume
and transaction cost drivers for a period in respect of XYZ Ltd:
Products
A B C Total
Sales and
90,00 30,00 135,00
production 15,000
0 0 0
(units)
Raw materials 1,320,0
10 7 14
usage (units) 00
Direct materials 4,125,0
30 40 15
cost (£) 00
Direct labour 337,50
2.5 3 1.5
hours 0
652,50
Machine hours 5 3 7.5
0
Direct labour 2,850,
20 30 10
cost (£) 000
Number of
5 10 50 65
production runs
Number of
18 7 50 75
deliveries
Number of
50 70 700 820
receipts
Number of
production 45 25 60 130
orders
Overhead costs £
Set up 75,000
1,000,00
Machines
0
Receiving 900,000
Packing 650,000
Engineering 750,000
Total 3,375,000
You are required to
(a) calculate the total costs for each product if all overhead

8. costs are absorbed on a labour hour basis;
(b) calculate the total costs for each product, using activity
based costing;
(c) calculate and list the unit product costs from your figures in
(a) and (b) above to show the differences between them and
to comment briefly on any conclusions which may be drawn
which could have pricing and profit implications.
Solution to the worked example
There is more extensive treatment of Activity Based Costing in
my book
We will be working through these data three times. Firstly to
see how traditional cost accounting methods might deal with
them; secondly to look at the multiple volume based overhead
method; and, finally, to look at the ABC method itself. Of the
three approaches we will be looking at, only ABC will be using
all of the data in any great detail. This is consistent with the
general nature of the traditional method, and the only slightly
more advanced multiple volume method.
ABC method
As we said above, to apply the ABC method, we need to
identify cost drivers for two stages:
1 cost drivers tracing the costs of inputs into cost pools; and
2 cost drivers tracing the cost pools into product costs
The workings that follow illustrate clearly how such cost drivers
work through the ABC system in these two stages: an initial
overhead rate or amount being further subdivided according
the needs of the situation.
workings:
The calculations for each of the rates to be used are:
The machine hour rate is the only rate that is what we might
call a traditional rate. All of the other rates we are about to use
involve a two stage process. We will see the elements of these
two stages as we get to them.

9. machine hour overhead rate
=
£1,000,000 £1.53
26
652,500
machine
hours
This rate is used as normal.
For the set up costs, we first devise a rate to tell us the cost
per set up: total set up overheads divided by the number of set
ups: in this case, this is
=
£75,000 £1,153.
85
65
production
runs
We will return to this rate shortly.
All of the other rates are calculated similarly. Hence they will be
presented now without further comment.
=
Receiving £900,00
£1,097.5
rate 0
6
820
receipts
=
£650,00
Packing rate £8,666.6
0
7
75
deliverie
s

10. =
Engineering £750,00
£5,769.2
rate 0
3
130
producti
on
orders
All of this information can now be put together into a cost per
unit statement as follows.
The final stage in the whole ABC procedure, as far as product
cost determination is concerned is to find out the costs per
unit. The cost per unit statement follows, and then we will work
through the calculations.
Unit costs A B C
£ £ £
Direct 30.000 40.00
15.000
materials 0 00
Direct 30.00
20.000 10.000
labour 0
Machine
7.6628 4.5977 11.4943
overheads
Set up 0.384
0.0641 3.8462
costs 6
Receiving
0.6098 2.5610 51.2195
costs
Packing 2.022 28.888
1.7333
costs 2 9
Engineering 23.076
2.8846 4.8077
costs 9
£143.525
Total Costs £62.9546 £84.3732
7
workings:
Machine overheads are found by multiplying the machine hour
rate by the number of machine hours per product per unit:

11. machine hour rate £1.5326 x
machine hours 5 3 7.5
£7.66 4.59 11.49
gives
28 77 43
The set up costs rate we have already is the rate per machine
set up, the cost per unit is calculated by multiplying the rate
per set up by the number of set up per product and then
dividing the results by the total number of units per product:
Set up cost per set up £1153.85 x
No of set ups 5 10 50
£0.0 0.00 0.05
gives
010 59 92
Set up cost per set up £1,153.85 x
No of set ups 5 10 50
£5,76 11,538 57,692
gives
9.25 .50 .50
these values are then divided by the number of units per
product to give us the cost per unit:
£0.0 0.38 3.84
641 46 62
The receiving, packing and engineering costs are all calculated
in the same way as the set up costs. There is no need to
repeat these calculations, but check that they are understood.
Summarising each of these methods now we can see the
impact of the different methods on product costs, Assuming
that the ABC method is really more effective than the
traditional approach, product A shows a cost difference of
£42.1085 per unit.

12. Summary 1: Total costs per unit using each of the three methods
Product
A B C
75.00 100.0 40.00
DLH
00 000 00
69.57 83.94 104.6
Mult
53 03 678
62.95 84.37 143.5
ABC
46 32 257
Summary 2: Overheads per unit using each of the three methods
Product
A B C
25.00 30.00 15.00
DLH
00 00 00
19.57 13.94 79.66
Mult
53 03 78
12.95 14.37 118.5
ABC
46 32 257
Summary 3: Overheads as a percentage of total costs
Product
A B C
33.3 30.0 37.5
DLH
3% 0% 0%
28.14 16.61 76.11
Mult
% % %
20.5 17.04 82.5
ABC
8% % 8%

13. Overall Activity Based Costing Sample
This example looks at the manufacture of PC
boards. For the purpose of this example, we
are only looking at the activity costs involved in
the assembly of the PC boards. This example
looks at the costs of developing two PC
boards. The first board (Board XXX) is
produced in a batch of 500 boards. The
second board (Board YYY) is produced in a
batch of 100 boards.
Identify Activities
The process flowchart shows the flow of the
following activities:
• Receive Materials - All parts
required for the assembly of the PC
boards are received, the parts are
counted and distributed to the required
physical locations throughout the
assembly process.
• Setup Machine for Board Type - All
machine setups for the particular board
are done.

14. • Start Board Assembly - Board
assembly is started for each board. This
includes the setup of the machine for
each board and ensuring all parts are
present.
• Insert Machine Handled
Components - Equipment inserts
components into the PC boards.
• Insert Manually Handled
Components - Skilled personnel insert
components into the PC boards.
• Solder Components - All
components inserted into the PC boards
are soldered.
• Complete Quality Assurance Testing
of Assembled Boards - The boards are
tested to ensure they have been
assembled correctly.
Identify Cost Measures
In looking at the General/Ledger (G/L), the
following cost accounts have been identified:
• direct costs for materials,
• direct costs for manufacturing
labour,
• material receiving costs,
• machine setup costs,
• machine costs,
• resource costs,
• quality assurance costs.
Additional information is required to determine
how some of the costs should be allocated to
the various activities. The information required
includes:
• the composition of the PC board
(e.g., number of parts to be inserted),

15. • time studies to determine how much
time it takes to complete manual and
machine activities,
• metered use of resources for each
relevant activity (e.g., electricity used in
the solder components activity). These
measures are used to allocate energy
costs to activity cost pools.
Identify Performance Measures
The following performance measures have
been identified for the activities in this process:
• number of rejected PC boards,
• cycle time required to assemble PC
boards,
• process time required to assemble
PC boards.
The cycle and process times are used to
evaluate the efficiency of the process. The
reject rate is used to evaluate the
effectiveness of the process.
Identify Relationships between Costs and Activities
This table summarizes the cost and activity
measures gathered. Measures have been
gathered for both boards produced in this
manufacturing process.
In looking at the activities and the G/L, the
following activity cost pools have been
identified and quantified. The values are
contained in the model below.
• material receiving costs,
• machine setup costs,
• initial board assembly costs,
• machine insertion costs,
• manual insertion costs,

16. • soldering costs,
• quality assurance testing costs.
As well, the direct costs for this process have
been quantified. These values are also
contained in the model below.
• material costs,
• manufacturing labour costs.
Identify Cost Drivers
The cost drivers have been determined for the
activity cost pools, and are summarized in this
table.
Model the Costs
In this example the model is developed using a
spreadsheet tool.
Interpret Results
The product cost varies depending on the use
of the activities. Although the material costs
for Board XXX are higher than those of Board
YYY, the total cost for Board XXX is less. This
is because Board XXX uses less of the more
expensive activities.
In looking at the activity costs (as calculated in
the model), the number of machine insertions
appears to be a key factor affecting the final
cost. Board XXX has a higher percentage of
machine insertions than Board YYY. Machine
insertions are much cheaper than manual
insertions (i.e., the cost to insert one
component by machine is $0.60 compared to
$3.75 to insert one component manually). As
well, because there are fewer manual
insertions, there is less chance of manual
error, resulting in less testing time and fewer
rejects. Therefore, if more components can be

17. inserted by machine, the product cost will
decrease. The component insertion costs will
decrease, and the testing cost may decrease
as well. The defect rate may also decrease, if
there are more machine insertions.
When examining the activity costs, the most
expensive activity is Receive Materials. The
more parts required for a board, the more
expensive is the activity. One way to reduce
costs is to reduce the number of parts in the
board. However, the goal here is to improve
the process, NOT to change the product. To
reduce costs, look closely at the activity
Receive Materials to determine ways to
improve this activity. Even a five cent
reduction per part, results in a cost reduction
of $2,375.00 (i.e., 47,500 parts * 0.05
dollar/part) in the Material Receiving Cost Pool.
Activity-Based Costing (ABC) arose in the 1980s from the
increasing lack of relevance of traditional cost accounting
methods. The traditional cost accounting methods were
designed around 1870 - 1920 and in those days industry was
labor intensive, there was no automation, the product variety
was small and the overhead costs in companies were
generally very low compared to today. However, from the
1960s - particularly 1980s - this changed rapidly. For these
reasons, and more, traditional cost accounting has been called
everything from 'number 1 enemy of production' and questions
whether it is 'an asset or a liability' have been raised.
The question of course is whether ABC has overcome these
deficiencies or not? It has. In fact, ABC has been called one of
the most important management innovations the last hundred
years.
So what is really the difference between ABC and traditional
cost accounting methods? Despite the enormous difference in
performance, there is three major differences:
1. In traditional cost accounting it is assumed that cost
objects consume resources whereas in ABC it is
assumed that cost objects consume activities.

18. 2. Traditional cost accounting mostly utilizes volume related
allocation bases while ABC uses drivers at various levels.
3. Traditional cost accounting is structure-oriented whereas
ABC is process-oriented.
This is discussed in more detail in the subsequent sections and
illustrated below.
But first, the direction of the arrows are different because ABC
brings detailed information from the processes up to assess
costs and manage capacity on many levels whereas traditional
cost accounting methods simply allocate costs, or capacity to
be correct, down onto the cost objects without considering any
'cause and effect' relations.
References
1. Consortium for Advanced Manufacturing-International
2. Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study
Perspective (Harvard Business School Press, 1987) ISBN 0-87584-186-4
3. Sapp, Richard, David Crawford and Steven Rebishcke "Article title?" Journal of
Bank Cost and Management Accounting (Volume 3, Number 2), 1990.
4. Author(s)? "Article title?" Journal of Bank Cost and Management Accounting
(Volume 4, Number 1), 1991.
5. Activity-Based Costing (ABC): In recent years, ABC has lost ground in the metric
wars. But it may be set for a resurgence, by David M. Katz
6. Police Service National ABC Model Manual of Guidance Version 2.3 June 2007
7. The Review of Policing Final Report by Sir Ronnie Flanagan February 2008
8. http://www.cxoamerica.com/images/pastissue/article/bo.jpg
http://www.cxoamerica.com
9. Costand Managemen tAccounting (1996) PrenticeHall ISBN 0-13-205923-1
10. . http://maaw.info/Chapter7Solutions.htm
11. http://www.emblemsvag.com/abc.htm