| Definition |
Activity-Based Costing (ABC) increases the accuracy of cost information by more precisely allocating overhead and other indirect costs to products or customer segments. Traditional accounting systems distribute indirect costs using bases such as direct labour hours, machine hours or material costs. ABC allocates overhead and other indirect costs by activity. These costs are traced from activities to products or customer segments based on the activities performed to meet actual demand. |
| Implementation |
ABC systems can replace traditional accounting systems or operate as standalone models. To build an ABC system, companies should:
- Determine key activities performed
- Determine cost drivers by activity
- Group overhead and other indirect costs by activity using identified drivers
- Collect data on activity demands (by product)
- Assign costs to products (based on activity usage)
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| Purpose |
Companies use the results of ABC analysis to:
- Re-price products:
Managers can more accurately analyse product profitability by combining ABC cost data with price information. Re-pricing or eliminating unprofitable products increases profitability. Lowering prices on products that had been subsidising unprofitable products increases volume.
- Reduce costs:
ABC analysis identifies the components of overhead costs and the drivers of cost variability. Managers can reduce costs by decreasing the cost of an activity or the number of activities per unit.
- Optimise new product design:
ABC systems provide accurate cost estimates of new products. Understanding cost drivers allows managers to design products more efficiently.
- Tailor incentive Systems:
ABC systems can help to establish specific performance measures and targets in pay-for-performance systems. This information can be used to align employee interests with corporate objectives.
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