Activity-Based Costing (ABC) is a system where the cost of each product or service is based on the amount of activity (direct and indirect labor) and materials that goes into its production or delivery. By understanding and allocating costs better, profit margins might improve.
The standard and more common accounting model is called “absorption” where labor costs (direct and indirect) are spread over all products produced. In absorption, the production or service delivery area will work to over-produce in order to spread the total cost of labor over a larger quantity of products or services. By doing this, the cost of the product looks lower on paper, even though the products that have been produced may not be required by the customer – resulting in the waste of inventory build-up, excess transportation, obsolescence, etc. (see 7 Lean Wastes).
Activity-Based Costing is an important concept in the world of Lean. ABC attempts to spread the true cost more accurately. To keep the cost of each product or service lower, the enterprise must produce only those items that are in demand or “pulled” by the customer (another fundamental Lean concept). When this happens, carrying extra labor capacity clearly impacts the cost of the product in a negative way.
Achieving Activity-Based Costing is difficult for many organizations. It requires fundamental changes in cost accounting and a highly cooperative interaction between operations and finance. When taken to extreme, ABC attempts to allocate all resources (including materials and all functional interactions) to the cost of each product or service.« Back to Glossary Index