Cost accounting began as a way to keep track of the true cost of an item or service by calculating the direct and indirect costs needed to produce that item or complete that service. Activity-based cost accounting (also called ABC for activity-based costing) is a method of accounting that gathers overhead costs for each activity performed by a company, then matches the costs to whatever or whomever is causing that activity. ABC is a more accurate way to attribute costs to activities and products than using traditional cost accounting methods.

Evolution of Activity-Based Cost Accounting

Before there was ABC, there was cost accounting. Cost accounting worked well for item or service-based businesses to generate the true cost of the production of an item or completion of a service. The direct costs of completing a project were added in with the indirect costs of overhead to arrive at the true cost. Over the years, many methods of cost accounting developed because of the inadequacies of the simple cost method.

The Arbitrary Nature of Cost Accounting

If a painting business is using cost accounting, the direct costs would include labor costs and materials costs. Indirect costs would include the administrative labor of the business owner and the use of depreciable items such as brushes, ladders or vehicles. These direct and indirect costs are subtracted from the revenues earned on the job to arrive at the profits made. Consistency becomes an issue in basic cost accounting because some companies may arbitrarily assign indirect costs based on something easy to track (direct labor hours). Others may assign indirect costs based on the amount of materials used.

Problems With Cost Accounting

Manufacturing and processing companies found it difficult to use cost accounting because tracking the processes used became very difficult. For example, a paper mill purchases lumber to create a number of different products using different techniques. One tree may produce a ream of paper and some salable by-products. Tracking the actual cost of the tree used to each individual product made or job completed was virtually impossible.

These companies then created what they called "Process Costing." Process Costing records the costs for each process or department, not for each job or unit. The costs to produce the paper are assigned to that process as well as the costs for by-products. The indirect costs are assigned to the process as well.

Activity-Based Cost Accounting is Born

Cost accounting and process accounting are difficult for companies with complex processes and manufacturing practices such as a company where many raw goods are used to create many different items. ABC was created out of the need to overcome these difficulties by dividing production into its core activities. After this division, the costs for these activities are calculated and allocated to products based on how much of a particular activity is needed to produce a product.

Advantages of Activity-Based Cost Accounting

Traditional methods of cost accounting do not take into account some of the costs associated with a product or service, which limits management's ability to accurately price the products and gauge production levels. ABC takes into account the production and non-production activities that go into the creation of a product. It separates the costs of production from the costs of administration, allowing for a more accurate picture of the true cost of creating a product based on actual production costs.

Disadvantages of Activity-Based Cost Accounting

While the information gained through ABC is extremely valuable, the IRS and stockholders require the use of traditional methods to create the necessary reports for taxes. ABC is not what is called Generally Accepted Accounting Principles (GAAP) and therefore cannot be used for official record keeping. This means that companies wishing to have the advantage of ABC techniques will have to use two different costing methods. Depending on the company, the use of two different costing methods may prove to be more costly than beneficial. However, many companies endure the additional work and believe the process to be well worth the extra time and expense.