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Failings of Traditional Accounting
Traditionally, accounting determined the cost of a product by looking at the cost of materials and the direct labor hours; plus some allocated overhead costs. For example, if a gear needed $5 dollars worth of steel and one-hour of machining at $10/labor hour then the accounting cost would be $15 plus some allocated overhead.
This worked well when material and direct labor accounted for most of the cost. However, in modern business, direct labor and material often only account for a small percentage of the cost of a product or service. Most of the cost is in "overhead" which includes everything from the building and equipment to the cost of the HR department. Overhead is allocated to products in a fairly arbitrary way so there is no way to know the true cost of a product.
Without knowing the true cost of a product or service, we don't know if we should continue to make it or where to look for savings.
Activity Based Costing as a Solution
ABC traces rather than allocates costs. It attempts to understand how activities are related to a product or service. For example, a product might require several machine set-ups, some engineering time and a certain amount of customer technical support. These are three of the costly activities we can trace to the product.
Having identified the activities, ABC looks for the "resource drivers": metrics that help us determine the cost. For example, set-up costs can be measured by the number of set-ups, engineering support by hours and technical support costs by the number of customer phone calls.
At last, we are in a position to accurately allocate the "overhead" costs of activities to a product based on how many set-ups, how many hours of engineering support and how many customer phone calls.
Limitations of Activity Based Costing
Activity Based Costing can be difficult and expensive to implement and maintain. It can not replace traditional accounting, which is required for legal reporting, so it becomes a second accounting system.
The benefits are potentially great but so are the costs. Hence, it is something to be approached thoughtfully.
What HR Needs to Know
One of the leading thinkers behind Activity Based Costing was Harvard's Robert S. Kaplan who published on the subject in the late 1980''s. Robert S. Kaplan is now becoming known to HR professionals through his work on the Balanced Scorecard which he invented with David Norton.