ABC is not a simple technique to implement but does provide a consistent way of measuring activity in highly people intensive industries.
For years, companies operated under the assumption that their cost information actually reflected the costs of their products and services when, in reality, it did nothing of the kind. Over-generalized cost systems were actually misleading decision makers, causing them to make decisions inconsistent with their organizations' needs and goals, principally because of misallocated costs. Activity-based costing (ABC) is a valuable concept that can be used to correct the shortcomings in the cost systems of the past.
"Activity-based costing is the best cost-accounting system for producing accurate, relevant information for making decisions, including how to estimate the cost of jobs or projects," says Gary Siegel, an associate professor at Chicago-based DePaul University's School of Accountancy and Management Information Systems and a certified public accountant.
Siegel, who has worked with numerous professional associations to develop and implement ABC models for their industries, explains that the essence of ABC is the idea that businesses are "activity-driven." ABC determines the cost of these activities and shows how these activities affect the cost of a product or service.
The concept behind Activity-based Costing is that costing should be much more than a financial system used by accountants; it should be a part of the profit making process of the business, a way of ensuring that resources are used effectively to add value to the organisation. The practical application of ABC involves integrating it with the management information systems of the organisation, not maintaining a separate costing system. To make this work the planning and performance systems should also be integrated so that there is one single souce of data about the activities, products, and transactions within the company.
This may seem obvious in a manufacturing company where prices are calculated based on production and raw materials costs but in financial services where a large part of the costs are interest and/or provisions for claims and losses, linkages between operating costs and use of staff are often managed without any consideration for product pricing, customer demand or capacity planning. ABC is often used as a means to an end - to manage the costs of people and technology in a coherent way.
As a result, in many organizations, ABC has evolved beyond the point of simply developing more accurate and relevant product, process, service and activity costs. These organizations use ABC as a means of improving operations by managing the drivers of the activities that cause costs to be incurred. They are using ABC to support major decisions on product lines, market segments and customer relationships, as well as to simulate the impact of process improvements. Organizations involved in Total Quality Management processes are also using both the financial and non-financial information of ABC as a measurement system.