Activity-based costing is a system of assigning costs to products or services based on the resources that they consume. Its aim, wrote The Economist, is "to change the way in which costs are counted".
Activity-based costing is an alternative to the traditional way of accounting in which a business's overheads (indirect costs such as lighting, heating and marketing) are allocated in proportion to an activity's direct costs. This is unsatisfactory because two activities that absorb the same direct costs can use very different amounts of overhead. A mass-produced industrial robot, for instance, may use the same amount of labour and materials as a customised robot. But the customised robot uses far more of the company engineers' time (an overhead) than does the mass-produced one.
This difference would not be reflected in traditional costing systems. Hence a company that makes more and more customised products (and bases its pricing on historic costings) can soon find itself making large losses. As new technologies make it easier for firms to customise products, the importance of allocating indirect costs accurately increases.
Introducing activity-based costing is not a simple task — it is by no means as easy as Activity-based costing. For a start, all business activities must be broken down into their discrete components. As part of its activity-based costing programme, for example, ABB, a Swiss-Swedish power company, divided its purchasing activity into things like negotiating with suppliers, updating the database, issuing purchase orders and handling complaints.
Large firms should try a pilot scheme before implementing the system throughout their organisation. The information essential for Activity-based costing may not be readily available and may have to be calculated specially for the purpose. This involves making many new measurements. Larger companies often hire consultants who are specialists in the area to help them get a system up and running.
The easy approach is to use Activity-based costing software in conjunction with a company's existing accounting system. The traditional system continues to be used as before, and the Activity-based costing structure is an extra to be called upon when specific cost information is required to help make a particular decision. The development of new business accounting software pro¬grams, such as those of SAP, a German software company, have made the introduction of activity-based costing more feasible.
Setting up an activity-based costing system is a prerequisite for improving business processes and for any re-engineering programme. Many firms also use activity-based costing data as inputs for the measures required for a balanced scorecard.
The idea of activity-based costing arose in the early 1980s largely as a result of growing dissatisfaction with traditional ways of allocating costs. The idea owes much to the work of Michael Porter, who developed the view of the business as a chain of interlinked activities. In his scheme, profits are no more than the sum of the difference between the price that customers pay for an activity and the cost of that activity. Measuring the cost of activities correctly then becomes central to making a profit.
After a strong start, however, activity-based costing fell into a period of disrepute. Even Robert Kaplan, a Harvard Business School professor sometimes credited with being its founding father, has admitted that it stagnated in the 1990s. The difficulty lay in translating the theory into action.