Allocation of Fixed Costs

How can Activity Based Management (ABM) and Activity Based Costing (ABC) benefit an organization?

Activity-based costing (ABC) is an accounting method that allows businesses to gather data about their operating costs. Costs are assigned to specific activities such as planning, engineering, or manufacturing then the activities are associated with different products or services. In this way, the ABC method enables a business to decide which products, services, and resources are increasing their profitability, and which are contributing to losses. Managers are then able to generate data to create a better budget and gain a greater overall understanding of the expenses that are required to keep the company running smoothly. Generally, activity-based costing is most effective when used over a long period of time, as opposed to shorter-term solutions such as the theory of constraints (TOC). The ABM method enables an organiztion to identify and evaluate their activities by using ABC to carry out a value chain analysis or a re-engineering initiative to improve strategic and operational decisions. Activity Based Management focuses on managing activities to reduce costs and improve customer value.

How does ABC differ from other allocation methods?

Most traditional costing systems utilize a single basis, (e.g. direct labor) to distribute the indirect costs to all products and services. This method of allocating indirect costs commonly results in erroneous cost data. Often products which have high volume (and high labor cost) are over costed. Likewise, the cost of lower volume products are often understated, and many of the indirect costs of these products are overlooked.

Rather than relying on a single basis to distribute costs, ABC assigns costs to activities and products based on how the costs (resources) are actually consumed by the process or product. By moving away from traditional cost allocation methods and using improved ABC methods of tracing and...