Activity-based costing: find the real cost of your products and customers

Most businesses know the purchase cost of what they sell. The trouble starts with everything else: order handling, picking, deliveries, customer service, credit control, set-ups and quality checks. Traditional costing spreads these overheads with one key, usually revenue or direct labour hours. That looks fair, but it charges a customer who orders twice a year as much overhead per euro as one who orders twice a day. Activity-based costing (ABC) replaces the single key with the activities that actually consume the overhead. The result is a cost per product and per customer that you can use for pricing, terms and mix.

Why use activity-based costing?

A revenue key undercosts everything that needs a lot of handling per euro of sales: small orders, special items, rush deliveries, demanding accounts. It overcosts large, standard, predictable business. As long as all customers behave alike, the error is small. Once they differ, the averages hide losses.

How activity-based costing works in five steps

1. 01

   Identify the main activities

   List what your overhead staff and resources actually do, such as taking orders, picking, delivering, invoicing and serving customers. Four to eight activities are enough to start.

2. 02

   Assign overhead costs to each activity

   Divide salaries, space, systems and vehicles over the activities, based on how people spend their time and what the resources are used for.

3. 03

   Choose a cost driver per activity

   A cost driver is the measurable event that makes an activity's cost go up: the number of orders, order lines, deliveries, set-ups or customer accounts.

4. 04

   Calculate a rate per driver

   Divide the cost of each activity by the total volume of its driver, for example the cost of order processing divided by the number of orders.

5. 05

   Apply the rates to products or customers

   Multiply each rate by the driver volume a product or customer group uses, add the direct costs, and compare the result with revenue.

Activity-based costing example: a distributor with two customer groups

Pellow Fixings distributes fasteners and fixings. It sells to installers, who order small quantities often, by phone and with fast delivery, and to manufacturers, who order larger quantities on a schedule through an online portal. Revenue is €3,000,000: €1,200,000 from installers at a gross margin of 38% and €1,800,000 from manufacturers at 25%. Overheads are €720,000. Spread by revenue, installers carry €288,000 and look like the better group. ABC tells another story:

Fictitious Firmfocus example. The logic works in any currency.

The total profit is the same; the picture is reversed. The manufacturers, who seemed to break even, earn more than the whole profit, because the installers make a loss. The installers' higher gross margin does not cover the cost of their many small orders, phone calls, deliveries and accounts.

Time-driven activity-based costing: the simpler version

Classic ABC asks staff how they divide their time, and the surveys have to be repeated whenever work changes. Robert Kaplan and Steven Anderson noted in Harvard Business Review in November 2004 that many companies that tried ABC gave up because of rising costs and staff irritation. Their alternative, time-driven ABC, needs two estimates per department.

How it works

• Cost per minute: the department's cost divided by its practical capacity in minutes, the time staff are really available after breaks, meetings and training.
• Minutes per activity: how long one unit of each activity takes, estimated by managers or measured.
• Time equations: a formula that adds minutes for the features that make an order take longer, such as extra lines or a phone order.

Pellow's order desk costs €240,000 and has four staff with a practical capacity of 80,000 minutes each, so 320,000 minutes at €0.75 a minute. Its time equation is ten minutes per order, plus two per order line, plus twelve if the order comes by phone or e-mail. Installers place 60% of their orders by phone.

Fictitious Firmfocus example, continued.

What it shows

The flat rate of €20 per order treated every order alike. The time equation shows that a three-line phone order costs €21.00 and the same order placed online €12.00. It also reveals €26,160 of unused capacity, a cost that belongs to no customer and that classic ABC would have spread over all of them. If half of the installers' phone orders moved online, another 34,560 minutes would come free, worth €25,920. Together with the capacity already unused, that is close to one full position on the desk.

From insight to action

ABC does not tell you to drop the installers. If Pellow stopped serving them, it would lose €456,000 of gross margin, but many overheads would stay: the warehouse, the systems, most of the vans. Only the costs that really disappear count in that decision. ABC tells you where to change terms and processes:

• Prices and fees: a minimum order value, a small-order fee or a free delivery threshold.
• Channel: move routine orders online and reserve phone time for advice.
• Service levels: fixed delivery days or counter collection for small orders.
• Accounts: occasional buyers to card payment instead of a credit account.
• Growth: pursue more manufacturer business, now that you know what it earns.

Then compare your margins per group with the industry figures, and use the cost gaps you find in the plan to reduce costs and improve profit.

Small firm or larger SME

Pitfalls

• Too much detail: fifty activities make the model expensive and nobody maintains it.
• Treating every assigned cost as avoidable: overheads assigned to a customer do not all vanish when the customer leaves.
• Theoretical capacity: dividing by all paid hours understates the cost per minute and hides unused capacity.
• A one-off exercise: rates go stale as processes, prices and customers change.
• Ignoring strategy: a loss-making customer can still be worth keeping, if you know why and set a limit.

The same logic sits behind the margin tip in the financial tips for SMEs, and behind the value chain analysis in strategy. More on costs, pricing and profit is in Finance.