"Costing" is when you break down business expenses and assign them to different parts of your business. You can cost your expenses such as materials, workforce and overhead based on geographic regions, customer accounts or the expenses per product. Activity-based costing (ABC) is a special approach to overhead, assigning the cost to items that actually use it. It's also known as activity-based allocation.
ABC and Overhead
Your business overhead is made up of all the administrative activities whose cost can't be neatly assigned to a particular product or project. Management salaries, legal bills, insurance, licenses and utilities are all overhead. ABC's advantage is that it's more accurate in assigning overhead expenses than other costing methods.
If you have two manufacturing processes that use equal numbers of machine-hours, most costing methods would assign them the same amount of overhead. If one process required a lot of testing, legal opinions and management oversight while the other required next to nothing, costing them equally distorts the allocation of overhead. The benefit of using ABC is that the process that demands the most overhead absorbs most of the costs. This gives you a more accurate snapshot of the costs of both projects.
How ABC Works
To cost using ABC, you start by identifying the costs to allocate. If you're dealing with project development, for example, R&D and testing are relevant costs, but costs related to shipping and warehousing are not. Next, you create cost pools for expenses tied to the process you're studying and secondary pools for expenses shared throughout the company. Then you use the ABC number-crunching formulae to assign costs to specific projects, products, geographic region or whatever it is you want to analyze.
ABC Advantage and Disadvantages
Knowing where your overhead goes can give you a better perspective on your company's costs. For example, using ABC on your customers might show you that some accounts require a lot more customer service than others. Some distribution channels may be eating up more administrative costs than others. ABC gives you better information about where your money's going, which helps you decide whether you're getting an adequate return.
ABC isn't perfect. Unlike some costing methods, you can't simply extract information from your ledgers. Instead, you need a lot of added data, sometimes from multiple different departments. The bigger and longer-lasting the ABC project, the more effort and expense it takes to collect information, and the greater the chance one or two departments will just forget about the relevant reports. It's also hard to assign overhead precisely: employees when asked which project they work on, may not give an accurate account. ABC projects work best if they're small and focused rather than embracing your entire operation.