Activity-Based
Costing System
Revealing the True Cost of
Products and Services
Introduction to Activity-Based Costing
Strategic Imperative
1 Accurately determining manufacturing costs is vital for effective
decision-making and competitive positioning in the market
Traditional Limitations
2 Traditional absorption costing may not adequately address overhead
allocation complexities for multiple products and services
ABC Advantage
3 ABC system accumulates overhead costs by organizational activities,
then assigns them to specific cost objects
Implementation Consideration
4 Cost-benefit analysis is essential as ABC system implementation
requires higher investments in time and analytical resources
Multiple Drivers
5 When overhead represents substantial product costs, multiple cost
drivers provide superior allocation accuracy
Origin and Development of ABC
Historical Context
The 1980s marked critical period when absorption
costing limitations became increasingly apparent to
organizations.
1
Global Adoption Market Evolution
ABC model became integral to management Traditional systems worked when companies
accounting curricula and organizational cost operated limited product ranges with
allocation methods worldwide. relatively low overhead costs.
Pioneering Research
David Cooper and Robert Kaplan developed ABC concept,
publishing foundational articles in 1990 and 1992.
Key Definitions and Terminology
Activity-Based Costing
Cost attribution to cost units based on benefits
received from indirect activities per CIMA
terminology.
Activity Definition
Any event that incurs costs within the
organizational operational framework and
resource consumption patterns.
Cost Object
Any product, service, process, or project
requiring separate cost measurement for
strategic decision-making purposes.
Activity Cost Pool
Total overhead costs allocated to specific activity
types or related operational activity groupings.
Cost Driver
Any factor or activity directly influencing
resource consumption patterns and associated
cost allocation requirements.
Overview of the Related Costing Systems
Absorption Costing Optimal Usage
Accounts for total product costs Traditional systems are effective when
using a single overhead rate based direct labor constitutes a significant
on production characteristics and portion; the ABC system is used when
volume technology dominates costs
1 2 3 4 5
Direct Costing Key Differentiator Strategic Orientation
Assigns only variable costs to ABC employs multiple cost drivers Traditional systems are cost-driven
products, emphasizing contribution versus traditional systems relying on while ABC systems maintain
to cover indirect operational single cost driver allocation process-driven strategic operational
expenses focus
When is ABC System Worth Using?
A Overheads are high in amount
N.B.: Not using the ABC system in such
B Products or customers are diverse environments is far more expensive than
implementing it. So, better implement it
rather than facing consequences in the form
of incorrect product or service or customer
costs leading to incorrect price settings.
C Business processes are complex Incorrect pricing is the major reason behind
product failure in the market.
D Pricing pressure and competition are intense
E Product or service profitability is unclear
The Framework of ABC System
Core Process
1 ABC distributes overhead costs across multiple activity cost pools,
then assigns them using specific cost drivers.
Implementation Steps
2 Identify necessary activities, assign overhead costs, determine cost drivers, calculate
predetermined rates, allocate costs.
Strategic Application
3 Serves as both a planning tool and management control mechanism
for pricing and profitability analysis.
Accuracy Enhancement
4 Establishes a clear relationship between overhead costs and production
activities through relevant activity levels.
Decision Support
5 Underpins critical business decisions including pricing strategies, inventory
valuation, and overhead allocation optimization.
Cost Drivers and Activity Levels
Batch-Level Activities Facility Support
Costs incurred per batch Administrative costs include
production include purchase depreciation, taxes, security,
1 orders, machine setups, and
3 insurance, accounting, and 5
comprehensive quality management salaries.
testing.
Unit-Level Activities Product-Line Activities Driver Categories
Costs directly related to 2 Costs specific to product 4 Transaction drivers count
individual units include lines include engineering occurrences; duration drivers
direct materials, labor, and changes, design measure time; intensity
machine maintenance modifications, and drivers weight resource
operations. warehousing requirements. consumption.
Advantages of ABC System
Cost Accuracy
1 Provides precise product and service costing through direct
activity linkage, improving financial decision-making.
Overhead Understanding
2 Management gains clearer visibility into overhead cost drivers and
their operational impact on profitability.
Process Integration
3 Aligns effectively with Six Sigma and continuous improvement
initiatives, facilitating enhanced operational efficiency.
Waste Identification
4 In-depth overhead analysis highlights non-value-added activities,
enabling better production waste control measures.
Performance Management
5 Supports comprehensive performance management frameworks
and balanced scorecard development for strategic alignment.
Strategic Benchmarking
6 Facilitates benchmarking against other products and enables
comprehensive performance comparisons across business units.
Drawbacks and Implementation Challenges
Implementation Costs Employee Buy-in
Requires a larger initial budget compared Requires convincing employees of ABC
to traditional costing methods with benefits and securing strong top
ongoing maintenance expenses management support throughout
implementation
Profit Reporting Resource Requirements
Often gives different product margins Demands cross-functional team design,
than traditional systems, potentially consultant engagement, and specialized
creating management confusion software selection with expert guidance
IFRS Compliance Time Investment
Reports don't adhere to IFRSs /IASs More time-consuming to implement and
under ABC, requiring dual cost systems operate, therefore, necessitating objective
for internal and external reporting collection of cost driver information
Industries Using ABC Successfully
Pharmaceuticals Manufacturing Sector
Understands research, development, and Effective in complex production
production costs, facilitating superior environments where overhead costs vary
budgeting and pricing for the strategic
initiatives 6 1 significantly between different product lines
Telecommunications Healthcare Organizations
Enables accurate cost assignment to Helps understand patient care costs,
different service lines, improving 5 2 enabling informed financial decisions
profitability analysis and strategic and strategic resource allocation
decision-making optimization
Aerospace Defense 4 3 Service Industries
Manages intricate costs in high regulatory Consulting and IT services benefit through
environments with sophisticated production improved insights into service delivery costs
and project management requirements and pricing strategies
Software Solutions for ABC System
Enterprise Solutions
1 Oracle NetSuite, SAP Business By Design, and Microsoft
Dynamics 365 provide comprehensive ABC functionality
Specialized Platforms
2 Sage Intacct and IBM Cognos Analytics offer dedicated cost
management and business intelligence capabilities
Industry-Specific Tools
3 Infor CloudSuite provides industry-specific solutions with
extensive ABC capabilities for detailed cost tracking
Dedicated Solutions
4 CostPerform focuses exclusively on ABC with extensive cost
analysis functionality for comprehensive management insights
Performance Management
5 Prophix and Workday Adaptive Planning support ABC
methodologies within broader financial planning frameworks
Visualization Integration
6 Tableau integrates with ABC data, providing insightful analytics
and comprehensive reporting for strategic decision-making
Manufacturing Company Example
ABC Implementation
Multiple cost drivers including
machine hours, purchase orders, and
setups provided more accurate cost
allocation.
Traditional Costing Cost Comparison
Single overhead rate of USD. 4 per ABC results: Product A: USD. 255.60
labor hour resulted in Product A: USD. (3.55% lower), Product B: USD. 396.50
265, Product B: USD. 302.50 per unit. (31.07% higher) than traditional
costing.
Alpha Ltd Strategic Impact
Manufacturing Products A and B with Traditional system overstated Product
identical processes but different A costs while understating Product B,
overhead allocation requirements and requiring ABC implementation for
cost structures. accuracy.
Service Company Example
Resource Allocation XYZ Consulting
Provides insights for strategic resource Management consulting firm with USD.
allocation and operational efficiency 5 1 100,000 overhead allocated across
improvements across service delivery client meetings, research, and report
activities preparation
Strategic Value 4 Activity Rates
ABC enables consulting firms to
2 Client meetings: USD. 200 per meeting,
understand activity-specific costs and Research: USD. 100 per hour, Report
make informed pricing decisions 3 preparation: USD. 1,000 per report
Client D Analysis
5 meetings, 20 research hours, and 3
reports resulted in a total service cost of
USD. 6,000 per client
Trading Company Example
Asad Trading Co Total Cost Operational Insights
Electronics trading company with Total budgeted operational costs of Helps trading companies optimize
5,000 annual units across order USD. 30,000 with cost per unit of USD. cost structures and make strategic
processing, warehousing, shipping, 6 for electronic trading operations operational decisions based on
and customer service activity analysis
1 3 5
2 4
Activity Costs Cost Structure
Order processing: USD. 10,000, ABC implementation enables
Warehousing: USD. 2,000, Shipping: understanding of actual trading
USD. 12,000, Customer Service: activity costs and informed pricing
USD. 6,000 annually decision-making processes
Important Question
When the ABC system is embedded in most of the ERPs, what is the purpose of all the
above discussions? The ERP vendor does all the job as a part of the implementation
exercise.
Even though ABC is embedded in most modern ERP systems, the discussion of ABC remains essential because an ERP only runs a costing
model. It does not design it, challenge it, or think for management. Software can allocate costs once activities, cost pools, and drivers are
defined, but it cannot understand how the business truly works. Only management can decide which activities really consume resources,
which ones add value, and which ones exist only because of poor processes or weak controls.
Vendors and consultants can technically configure ABC inside an ERP, but they cannot judge whether a customer order, a machine setup,
a design change, or a sales visit is the real driver of cost in your business. They also cannot decide how costs should be interpreted for
pricing, product mix, outsourcing, customer profitability, or market strategy. These are economic and managerial judgments, not IT
decisions.
If management does not understand ABC, the ERP will simply automate bad assumptions. Wrong cost drivers, poorly defined activities, or
incomplete cost pools will still produce neat-looking reports, but the numbers will be misleading. This creates a dangerous situation
where managers trust the system while being guided by distorted cost information, leading to wrong pricing, loss-making customers
being subsidized, and profitable products being dropped.
ABC is therefore not a software feature. It is a way of thinking about how resources are consumed by activities and how those activities
serve products, services, and customers. The ERP only provides speed, scale, and data handling. The real value of ABC comes from
management using that information to challenge processes, remove waste, redesign workflows, and make better strategic choices.
In short, ABC must be understood and actively used by management. Without that understanding, an ERP will only make a poor costing
model run faster, not make it correct.
Utilizing ABC System in the Strategic Decision-Making Process
ABC system supports some of the most important business decisions, such as:
Product Pricing Decisions
ABC shows the true cost of serving each product and customer. This costing method prevents underpricing
or overpricing of products or services.
Making Customer Profitability Analysis
Some customers order small quantities, demand fast delivery, require many changes, and call support often.
ABC reveals whether they are worth keeping.
Product Design Finalization
ABC highlights which design (features) drives cost more or less, thus allowing engineers to design products
for higher profitability.
Outsourcing Expensive Activities
ABC shows which activities are more expensive internally and may be cheaper outside, thus allowing
outsourcing of such activities.
Production Capacity Management
ABC separates unused capacity from used capacity, thus making inefficiencies visible to management.
Activity-Based Management Approach
Strategic Framework Strategic Alignment
1 ABM uses ABC insights to optimize
processes, reduce costs, and enhance
4 Encourages alignment of activities with
strategic objectives, ensuring effective
overall organizational effectiveness resource allocation and operational focus
Performance Improvement Data-Driven Decisions
2 Emphasizes continuous improvement by
identifying inefficiencies in processes and
5 Relies on comprehensive data analysis to
guide management decisions, making it
operational activities systematically more strategic than traditional approaches
Cost Control Proactive Management
3 Understanding activity-specific costs
enables informed decisions to minimize
6 Focuses on strategic management and
process improvement rather than reactive
waste and optimize resource utilization budgeting and basic cost control
Activity-Based Budgeting Framework
Strategic Purpose
ABB plans future expenses by setting budgets 1
based on activities required to achieve
organizational goals.
Planning Focus
2 Uses ABC insights to create budgets reflecting
resources needed for performing planned
strategic activities.
Implementation Process
Define objectives, identify required activities, 3
estimate costs using ABC data, and compile
comprehensive strategic budgets.
Resource Alignment
4 Results in well-structured budgets aligning
spending with strategic priorities and ensuring
efficient resource allocation.
ABC Integration
Builds upon ABC cost information to estimate 5
future activity costs and create
comprehensive organizational budgets.
Beyond Costing, Toward Better Management
The ABC system delivers accurate product and service costs by
allocating overheads based on the activities that actually consume
resources, rather than spreading them uniformly across all outputs.
It, therefore, goes beyond costing and becomes a way of
understanding how the business truly operates through its cost
drivers and activities.
This visibility allows management to see where money is spent,
why it is spent, and how processes, products, and customers can
be managed more efficiently and effectively.