Cost accountants know that traditional costing can skew the picture of real production costs for individual products. Some businesses turn instead to Activity Based Costing for a truer measure of costs.
The income statement gross margin, for instance, is in fact an average for all products (or entire product lines). The real gross margins for individual products can tell a very different story: A high overall GM can obscure the fact that the company is actually taking a loss on some products.
Why Adopt Activity Based Costing?
Management is moved to adopt ABC by the desire to improve costing accuracy—get closer to the true cost and true profitability—of individual products and services. They are also moved by a desire to understand better the true costs and ROI from projects or other initiatives.
See the online article Activity Based Costing for a complete introduction to ABC.
Companies try ABC specifically to
- Identify products that are truly unprofitable.
- Find the true costs of products so as to support pricing policy.
- Reveal truly unnecessary costs that can be eliminated.
ABC pursues these objectives essentially by making direct costs out of many costs that traditional costing treats as indirect costs. Examples in the article Activity Based Costing below show how to do this.
Activity Based Costing, however, has a reputation for being difficult to apply and labor-intensive. This is because ABC requires detailed tracking of workflow processes and resource usage. AbC also requires analysis beyond the normal practice in project control and financial accounting.
Any business thinking about adopting ABC naturally asks “Is it 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 test activity based costing on a few products, easily, without resorting to full-blown ABC system. 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 a complete overview of 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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