Activity-Based Costing: Understanding True Product and Customer Costs

Why does Customer A seem profitable on paper but generate constant headaches? Why does Product X have great margins while consuming disproportionate resources? Traditional accounting often can't answer these questions. ABC can.

Activity-based costing links costs to the activities that cause them, then links activities to the products, customers, or services that consume them. The result is a clearer picture of what actually drives your costs—and who should pay for them.

The Problem with Traditional Cost Allocation

Traditional costing typically allocates overhead based on simple metrics like revenue, direct labor hours, or units produced. This can dramatically distort profitability.

Example: Two Products

Traditional Allocation (by units)

Overhead per unit: $100,000 ÷ 11,000 = $9.09

• Product A: $50 - $30 - $9.09 = $10.91 profit/unit × 10,000 = $109,100
• Product B: $100 - $50 - $9.09 = $40.91 profit/unit × 1,000 = $40,910

But what if Product B actually consumes more overhead? It requires custom setups, more quality inspections, and generates more support calls. ABC would reveal this.

ABC Methodology

Step 1: Identify Activities

Activities are the work performed that consumes resources. Examples:

• Processing orders
• Setting up production runs
• Quality inspections
• Customer support calls
• Shipping and handling
• Billing and collections

Step 2: Determine Cost Drivers

Cost drivers are measurable factors that cause activity costs to vary:

Step 3: Calculate Activity Rates

Divide total activity cost by total driver quantity:

Step 4: Assign Costs to Products/Customers

Multiply activity rate by each product/customer's consumption:

• Product A: 2,000 orders × $20 = $40,000 order processing cost
• Product B: 500 orders × $20 = $10,000 order processing cost

Customer Profitability Analysis

ABC is particularly powerful for understanding customer profitability. Revenue doesn't equal profitability—customers have different service costs.

Customer Cost Drivers

• Order frequency: Many small orders cost more than few large ones
• Customization: Special requests consume resources
• Support requirements: Some customers need more hand-holding
• Payment behavior: Late payers cost collection effort
• Returns and complaints: Each one consumes resources

Example Customer Analysis

Same revenue, very different profitability. Without ABC, you might treat these customers identically—or worse, give the high-cost customer more attention because they're "demanding."

Practical Implementation

Start Simple

You don't need to trace every dollar. Focus on material costs:

• Identify your largest overhead categories
• Pick 5-10 significant activities
• Choose logical cost drivers you can actually measure
• Accept estimates—precision isn't the goal, insight is

Data Requirements

• Cost data by department or function
• Activity consumption data (orders, tickets, setups, etc.)
• Customer/product-level transaction data
• Time estimates for activities (staff interviews)

Common Pitfalls

• Over-engineering: Too many activities and drivers creates complexity without insight
• Poor data: ABC results are only as good as the underlying data
• One-time analysis: ABC should inform ongoing decisions, not be a one-time project
• Ignoring results: ABC that doesn't change decisions is wasted effort

Using ABC Results

Pricing Decisions

ABC analysis often reveals that your discounting practices are costing more than you realize when true customer costs are considered.

• Adjust pricing to reflect true costs
• Add fees for cost-driving activities (small orders, customization)
• Offer discounts for cost-reducing behaviors (larger orders, self-service)

Customer Management

• Segment customers by profitability, not just revenue
• Invest in growing profitable customer relationships
• Address unprofitable customers (reprice, change service model, or exit)

Process Improvement

• Focus cost reduction on high-cost activities
• Identify non-value-adding activities to eliminate
• Design products/services to minimize resource consumption