by Merlin Hernandez


Computerized planning systems and automation have resulted in a greater visibility of cost drivers and reduction in direct labor. This allows more efficient manipulation of the costs of resources consumed by a particular activity involved in producing an item in order to reduce costs. The way costs are assigned to a product has an impact on the measurement of its profitability. The anomaly has been the separation of direct labor (used to compute both direct and indirect costs), and overhead – a relationship which has thus become skewed by the use of a predetermined overhead as a percentage of overall costs. With the use of more complex manufacturing processes, multiple allocation bases have become necessary in the computation of more accurate product costs.

Activity Based Accounting (ABC) is a costing model for allocating overhead costs that identifies a company’s range of activities and allocates the full costs to each, rolling overheads into direct costs but in a way that facilitates more efficient cost allocations. Cost drivers are expanded to include the full activity pool with overhead as a factor of each activity pool e.g. material ordering is assigned to material costs or equipment set up and maintenance assigned to the equipment cost driver. This represents a more logical and accurate allocation of costs than a single overhead rate, determined by a percentage of direct labor costs and applied across the board, in determining the exact cost of a product or service. Some activities demand more overhead input than others and cost rationalization will need more careful identification of potential areas of savings. This will enable the business to more effectively analyze and strategize for profitability way before scorched earth “cost cutting measures” need to be adopted.

ABC is best used over a long period of time to gather sufficient data for meaningful analysis. It also facilitates planning and budget development and helps to identify and devise HR programs increased efficiency and productivity. It is used in costing and cost controls, process improvement, product profitability, and customer profitability in manufacturing firms, communication firms, financial services, and the public sector. The method might be challenging for the construction industry due to wide cost variability among jobs. Critics of ABC have long argued that the system does not provide day-to-day guidance on process quality nor effectively measure short-term costs the way an ERP system can. But ABC remains viable as the system has expanded its scope beyond accounting to include supply chain and logistics, among other applications, and still emerge less expensive to acquire and maintain than ERP systems. It is ideal for the small business.

ERP systems integrate transactions but may not give an indication of which products to sell or which customers to cultivate. ABC is more adept at addressing these omissions. An integration of ABC with other data sources through business intelligence systems or ABC’s ETL (extract, transfer, load) technology can also address the problem of error or real time information usage. Some large organizations use a combination of ERP for full integration of transactions within the supply chain in addition to ABC for better product and customer analytics in order to drive performance improvements. The ERP becomes a real time data source for the ABC system to allow better day-to-day analyses.

Related articles on this blog

• Controlling Manufacturing Processes
• ERP Systems and Fashion Production
• Managing Small Business Finance 

• Supply Chain Management

Merlin Hernandez is an entrepreneurial development and management consultant who operates mainly in the small and medium enterprise sector. For more information on this and other topics, please send enquiries to