Cost accountants know that traditional costing can skew their measures of product production costs. Thus, many firms turn instead to Activity-Based Costing.
Companies that produce what they sell know well they must understand product costs accurately and in detail. This kind of information is essential for planning operations, pricing, and evaluating business margins. For product cost data, management relies on the firm’s cost accountants. But how, precisely, do the accountants develop this information?
Why Adopt Activity-Based Costing?
The Income statement gross margin is in fact an average for all products (or entire product lines). The real gross profits and gross margins for each product can tell a very different story: A high overall GM, for instance, can obscure the reality that the firm actually takes a loss on particular products. The problem is that traditional product costing methods do not always show particular product costs accurately.
Managers turn from traditional costing to activity-based costing driven by a keen want to improve costing accuracy—get closer to the true cost and true profitability—of individual products and services. They are also moved by a wish to understand better the true costs and ROI from projects or other initiatives.
Companies Try ABC When they Need Accuracy
Companies try out ABC in their own environments to find out how well the method:
- Identifies products that are truly unprofitable.
- Finds the true costs of products to support pricing policy.
- Reveals truly unnecessary costs for elimination.
How Does Activity-Based Costing Work?
ABC pursues these goals essentially by making direct costs out of many costs that traditional costing treats as indirect costs. In this way, therefore, ABC aims to remedy some of the costing inaccuracies that occur, inevitably, under traditional cost allocation.
However, activity-based costing is known for being difficult to apply and labor-intensive. This reputation, no doubt, is partly due to ABC’s extensive data needs. ABC calculations need, for instance:
- Complete tracking data for workflow process details.
- Product-specific resource-consumption metrics.
Also, ABC requires analysis and calculations beyond traditional practice in project control and financial accounting. Further comparison of traditional costing vs. ABC methods is beyond the scope of this article. However, detailed examples of the kinds of assumptions and calculations that carry out this transformation appear online in the article “Activity Based Costing.”
Asking the Critical Question
Senior managers no doubt begin thinking about ABC when they discover that gross margins are sinking. Or, they may consider ABC when they cannot account for poor product portfolio performance—even though sales and market share are on the rise. However, experienced product managers are also well-aware that ABC has a seriously adverse reputation as a difficult and labor-intensive system. Thus, any business thinking about adopting ABC naturally asks first “Is ABC worth our time and effort?
A fast answer to that question is simply:
You won’t know until you try it.
The good news, however, is that you can readily estimate the potential worth of activity-based costing for your own environment, by testing ABC on just a few products. These test trails serve as a “proof-of-concept” experiment that does not need full-blown ABC treatment for the entire product set.
Your test results will be trustworthy, however, only if you test n your own setting, with your own process, and your own employees. Measures of “ABC worth” from another company setting may move you to look into ABC for yourself, but the quantitative results do not generalize well from one environment to another.
Will the results shock you? Maybe yes, maybe no. But you won’t know until you try it.
Where to Go From Here? Take Action!
For more on ABC please see the online article Activity Based Costing. The article includes step-by-step “how-to” details, and shows with examples how traditional costing and ABC can differ.
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