Basics of activity based costing (ABC)

Something like activity based costing or ABC comes into the scene when we are talking about some sort of production activity. Production essentially is a composition of procedures, which use materials, services etc to produce the end result, which normally are sellable goods. As such the company purchases materials, buys services, develops internal expenses (personnel, asset related depreciation etc) which usually are designated to their cost center on the income statement.

Although cost centers are essentially required to measure company’s performance in different departments, to help keeping costs on certain level and so on, it does not show you if certain procedure could be done more efficiently.

Say the company spends 10,000 EUR on maintenance department expenses (materials, outsourced services etc) and this department takes care of the building the production is done, the building the supporting departments like admin is situated in as well as keeping all the machinery in shape and working. If we want to know how much certain procedure costs us, this maintenance expense needs to be slit onto various procedures related to production.

To be fair, it isn’t always easy to measure how much exactly from certain expense goes to certain activity when we talk about machinery. It is fairly easy to assess the amount of maintenance required on buildings, however, with machines, especially when there are more of them, it may become overly complicated and not even worthwhile to be split between processes. This is where you take the expense, tie it to procedures and reasonably assess the percentage from this expense goes to which specific procedure.

It is eventually all about reasonable assessment and business and production-wide knowledge. There is no right or wrong answer, just basic insight to the company and its doings.