Lean Finance and Operations

When I first stepped into the world of cost accounting, I thought I had a decent handle on how product costs were calculated. Overhead? Just spread it across units. Easy, right? But that all changed during my first manufcturing plant visit. I watched two very different products—one simple, one complex—go through the same production line. Yet, they were being assigned the same amount of overhead per unit. That didn’t feel right.

That’s when I was introduced to Activity-Based Costing, or ABC. And honestly, it changed everything about how I understood costs, profitability, and decision-making.

What is ABC Costing?

Activity-Based Costing is a costing methodology that assigns overhead and indirect costs to specific activities—like machine setups, packaging, inspections, and scheduling—and then assigns those activity costs to products based on how much each product uses them.

This differs from traditional Costing, which often allocates overhead using a single metric such as direct labor hours or machine hours. While simpler, traditional Costing can distort the true cost of products, especially in businesses with varied product lines and complex operations.

Why ABC Matters

Imagine you produce two products:

• Product A is simple and requires minimal resources.
• Product B is complex, needs multiple quality checks, and frequent setup changes.

Under traditional Costing, both might receive the same overhead rate based on hours worked. But Product B clearly consumes more resources. That’s the problem ABC solves—it links costs to actual activities and shows you where your money really goes.

In my experience, once we implemented ABC in that first plant, we uncovered surprising insights. Products we thought were highly profitable were actually losing money due to hidden overhead consumption. On the flip side, some low-volume products turned out to be more profitable than expected. It opened our eyes and gave leadership the data needed to make better strategic decisions.

How ABC Works – The Basics

Implementing ABC involves four steps:

1. Identify Activities
2. Break down the business into key processes, like material handling, setup, and quality control.
3. Assign Costs to Activities
4. Calculate the total cost for each activity, such as labor, supplies, and equipment depreciation.
5. Determine Cost Drivers
6. A cost driver is what causes the cost of an activity to increase (e.g., number of setups, inspections).
7. Assign Costs to Products
8. Allocate activity costs to products based on their actual usage of each activity.

It sounds like a lot, and it can be at first. But the clarity it provides is well worth the effort.

Real Benefits I’ve Seen

• Pricing with Confidence: With ABC, our team could set prices that reflected true production costs, not guesses or averages.
• Targeted Cost Reduction: We stopped cutting costs unthinkingly and started trimming specific non-value-added activities.
• Product Line Strategy: ABC helped us identify unprofitable SKUs and guided us on which ones to keep, improve, or drop.

This approach is particularly useful in manufacturing, healthcare, and service-based industries where indirect costs play a large role.

Is ABC Right for You?

If your business has:

• A variety of products or services,
• High overhead or indirect costs, or
• Complex processes that vary widely in resource usage,

…then ABC costing can give you a more accurate view of cost and value.

It’s not always necessary for small, simple operations. But if you’ve ever looked at your profit margins and felt something doesn’t add up, ABC is worth a closer look.

Final Thoughts

That first plant visit taught me something invaluable: Not all costs are created equal. By digging deeper into the why and how behind costs, ABC costing gave our team clarity, better margins, and smarter decisions.

As Robert S. Kaplan and Robin Cooper—two pioneers of ABC—wrote in “Cost & Effect” (Harvard Business School Press, 1997), “Too often, companies focus on how to cut costs, instead of understanding where they come from in the first place.”

If you want to stop guessing and start managing with precision, Activity-Based Costing might be your best next step.

References:

Cokins, G. (2001). Activity-Based Cost Management: An Executive’s Guide. Wiley.t to stop guessing and start managing with precision, Activity-Based Costing might be your best next step.

Kaplan, R.S. & Cooper, R. (1997). Cost & Effect: Using Integrated Cost Systems to Drive Profitability and Performance. Harvard Business School Press.

Horngren, C.T., Datar, S.M., & Rajan, M.V. (2020). Cost Accounting: A Managerial Emphasis (16th Edition). Pearson.