Activity Based Costing (ABC) - LSS Glossary

Activity based costing (ABC) is a methodology used to assign costs to products or services by tracing them to the activities that are the source of the costs. This method is more accurate than traditional methods, such as using a single overhead rate, because it takes into account the varying costs associated with different activities. Activity based costing is commonly used in manufacturing, but can also be applied to service industries and government organizations.

The basic principle of Activity based costing is that different products or services require different levels of resources, such as materials, labor, and overhead, to produce. Traditional costing methods do not take into account the specific resources required for each product or service, which can lead to inaccurate cost estimates.

Activity based costing, on the other hand, begins by identifying the specific activities that are required to produce a particular product or service. It then assigns costs to these activities based on the resources they consume. The costs associated with each activity are then allocated to the products or services that use the activity. This provids a more accurate cost estimate.

Advantages of Activity based costing

Better product or service costing: ABC provides more accurate product or service cost information than traditional methods.
Improved cost control: ABC helps identify and eliminate non-value-added activities, which can lead to cost savings.
Better decision-making: ABC provides more accurate and relevant cost information for pricing and other strategic decisions.
Better understanding of the business: Activity based costing provides a better understanding of the business by identifying and measuring the cost of activities, resources, and drivers.

Implementation of Activity based costing

Identify the products or services that the organization provides.
Identify the activities that are required to produce the products or services.
Identify the resources that are consumed by the activities.
Identify the drivers that cause the consumption of resources.
Assign costs to the activities.
Assign costs to the products or services based on their consumption of the activities.

Challenges and Limitations of Activity based costing

Complexity: Activity based costing can be complex to implement and maintain.
Data collection and measurement: ABC requires accurate data collection and measurement, which can be time-consuming and costly.
Limited applicability: ABC may not be appropriate for all organizations or products.
Resistance to change: Activity based costing may be met with resistance from employees who are used to traditional methods.

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Sachin Naik

Passionate about improving processes and systems | Lean Six Sigma practitioner, trainer and coach for 14+ years consulting giant corporations and fortune 500 companies on Operational Excellence | Start-up enthusiast | Change Management and Design Thinking student | Love to ride and drive