Costs that are often thought of as “overheads” can represent a large proportion of an organisation’s expenses. If these costs are arbitrarily allocated to satisfy accounting requirements, poor management decisions can result.

Activity Based Costing (ABC) is a method that recognises that your products, services, distribution channels and customers create the demand for activities to be performed. It is these activities that cause expenditure of resources.

By tracing the link between activity and resource expenditure, and then identifying the demand that each product, service, distribution channel or customer segment has on each activity, the true cost drivers of your “overheads” can be identified and tracked.

ABC studies have often uncovered cost distortions that dramatically affect the analysis of product and customer profitability.

To mention just one such example, the management of Diamant Boart were shocked when an ABC analysis showed that a major customer who contributed 6%-7% of total revenues was in fact quite unprofitable…

The sales force (who were paid commissions on sales rather than profits!) were reluctant to consider the expensive services provided especially for the customer as a cost directly related to that customer. Although buried as “overheads”, these costs were uncovered by the ABC study¹.

Although ABC has its origins in the manufacturing industry, it has proven to be of enormous benefit to service industries, from health care funds to telecommunications and energy providers.

¹ “ABC: Why it’s tried and how it succeeds” by Kip R Krumwiede, Management Accounting (US), April 1998 pp32-38.