Activity Based Costing (ABC) Method - Explained
What is Activity-Based Costing?
Written by Jason Gordon
Updated at September 13th, 2021
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Table of Contents
What is the Activity Based Costing? How does Activity Based Costing Work? Academic Research for the ABC MethodWhat is the Activity Based Costing?
The ABC (Activity Based Costing) method of cost accounting pertains to a company's resource-consuming activities that create costs. It uses physical, monetary and non-monetary indicators to measure these costs and assumes a split variation of the total cost model, which imputes and distributes all of the costs among the company's products. Plainly put, it allocates all of a company's costs of operations to specific activities that the company carries out.
Back to: ACCOUNTING, TAX, & REPORTING
How does Activity Based Costing Work?
ABC applies to a company's main activities -- which are integral to the companys purpose -- and secondary activities -- which generate added value for consumers but are subcontracted because they're too costly for the company to assume. This lets you know the amount and cost of each activity's resources. Specifically, ABC:
- Pays special attention to product planning and design costs
- Measures factors such as quality, delivery times, flexibility, innovation and after-sales service and contrasts these measures to traditional cost system operations
- Provides a more detailed and big-picture analysis of the cost-basis of activities than traditional systems.
After the company defines the tasks it performs, ABC determines how costs are distributed among the activities by analyzing inductors, which are factors influencing how much time, money and resources the activities consume. There are three such inductors:
- Transaction inductors, which consider how often an activity is repeated to calculate its average cost
- Inductors of duration, which tell how long it takes to perform each activity
- Inductors of intensity, which measure resource consumption every time an activity is performed.
ABC is superior to traditional cost quantification systems that focus on materials because it emphasizes activity costs and the added value activities bring to company products.
Academic Research for the ABC Method
- A survey of activity-based costing in the UK's largest companies, Innes, J., & Mitchell, F. (1995). A survey of activity-based costing in the UK's largest companies. Management accounting research, 6(2), 137-153. This survey of ABC adoption by the U.K.s 1,000 largest companies shows that many companies use the method but that its scope is frequently limited and that most companies havent decided whether or not to use it. Those companies that do us ABC apply it in all core management accounting functions.
- Vendor selection and evaluation an activity based costing approach, Roodhooft, F., & Konings, J. (1997). Vendor selection and evaluation an activity based costing approach. European journal of operational research, 96(1), 97-102. This is a proposal to use ABC to more objectively select and evaluate vendors by computing how much money a supplier costs a companys production process. It also shows how to decompose the difference between the budgeted and actual total vendor score into purchaser, supplier and combined effects.
- Towards explaining activity-based costing failure: accounting and control in a decentralized organization, Malmi, T. (1997). Towards explaining activity-based costing failure: accounting and control in a decentralized organization. Management accounting research, 8(4), 459-480. This study asserts that claims of ABC system failures may be overstated because they assess ABC as a decision-making tool and, in doing so, fail to appreciate the impact of accounting and control systems. The study also showed that a particular organizations resistance to ABC arose from fundamentally structural sources associated with the assessment of ABC costs and benefits, and with the influences of organizational power, politics and culture. As such, its unlikely that strategies for implementing ABC can overcome that resistance.
- Profit priorities from activity-based costing, Cooper, R., & Kaplan, R. S. (1991). Profit priorities from activity-based costing. Harvard business review, 69(3), 130-135.
- Activity-based costing in Ireland: Barriers to, and opportunities for, change, CLlarke, P. J., Hill, N. T., & Stevens, K. (1999). Activity-based costing in Ireland: Barriers to, and opportunities for, change. Critical perspectives on Accounting, 10(4), 443-468. This paper posits that Irelands lower rate of ABC adoption than that of Anglo-American countries results from supply and demand barriers to the transfer of management accounting practices; specifically, a dearth of compulsory continuing professional education, management accounting practitioner journals and executive MBA programs has left Ireland with few innovative managerial accountants. Moreover, theres no demand for sweeping changes in the accounting curricula within the Irish business and academic communities.
- Implementing activity-based costing (ABC) in logistics, Pohlen, T. L., & La Londe, B. J. (1994). Implementing activity-based costing (ABC) in logistics. Journal of Business Logistics, 15(2), 1.
- The benefits of activity-based cost management to the manufacturing industry, Swenson, D. (1995). The benefits of activity-based cost management to the manufacturing industry. Journal of management accounting research, 7, 167.
- The role of manufacturing practices in mediating the impact of activity-based costing on plant performance, Banker, R. D., Bardhan, I. R., & Chen, T. Y. (2008). The role of manufacturing practices in mediating the impact of activity-based costing on plant performance. Accounting, organizations and society, 33(1), 1-19. This study of how ABC affects plant performance and the adoption of world-class manufacturing (WCM) practices in U.S. manufacturing plants concludes that measurements of improved unit manufacturing costs, cycle time and product quality show the ABC doesnt directly impact plant performance significantly. Yet it also shows that WCM practices are critical to understanding the total impact of ABC because they increase whatever positive impact ABC has on plant performance.
- The impact of activity-based costing techniques on firm performance, Kennedy, T., & Affleck-Graves, J. (2001). The impact of activity-based costing techniques on firm performance. Journal of management accounting research, 13(1), 19-45. This paper shows that choosing ABC may be very beneficial to company value. It bases that conclusion on a survey which found that a sample of U.K. firms that adopted ABC techniques outperformed non-ABC firms by about 27 percent over a three-year period. It further suggests that ABC increases company value through improved cost controls and asset utilization, and more use of financial leverage.
- Activity-based costing/management and its implications for operations management, Gupta, M., & Galloway, K. (2003). Activity-based costing/management and its implications for operations management. Technovation, 23(2), 131-138. This paper demonstrates how an Activity-Based Costing/Management (ABC/M) information system supports effective operational decision-making in the areas of product planning and design, quality management and control, and inventory, capacity, and workforce management.