Activity-based costing (ABC) is a costing method that assigns overhead costs to products or services based on the activities that drive those costs, rather than using simple volume-based allocation. By identifying cost drivers and tracing overheads to activities, ABC provides more accurate product and customer profitability analysis.
In Depth
Traditional costing methods allocate overhead using a single basis — typically direct labour hours, machine hours, or units produced. Activity-based costing recognises that overhead costs are driven by a variety of activities, and different products consume these activities in different proportions.
The ABC process involves identifying all activities performed (order processing, quality inspection, machine setup, customer support), determining the cost of each activity (the cost pool), identifying the cost driver for each activity (number of orders, number of inspections, number of setups, number of support tickets), and allocating costs to products based on their consumption of each activity.
ABC is most valuable when overhead is a significant portion of total costs, when different products consume overhead resources disproportionately, or when management needs accurate product-level profitability for pricing and portfolio decisions.
The classic example involves high-volume simple products subsidising low-volume complex products under traditional costing. A manufacturer might discover that its small-batch custom orders consume 40% of overhead resources despite representing only 10% of revenue. ABC reveals this cross-subsidy, enabling more informed pricing and product strategy.
FP&A teams increasingly apply ABC principles to customer profitability analysis. Enterprise customers may generate high revenue but consume disproportionate support, implementation, and account management resources. ABC reveals which customers are truly profitable and which destroy value after accounting for all activities.
For UK service businesses where labour is the primary overhead, ABC helps allocate shared team costs to different service lines, projects, or client relationships.
Real-World Example
A UK insurance brokerage applies ABC to its three product lines. Traditional costing (allocation by premium volume) shows all three lines at 15% margin. ABC reveals that commercial property (low complexity, few claims) achieves 22% margin, while professional indemnity (high complexity, frequent claims) achieves only 6%. The FP&A team recommends price increases for PI policies and resource reallocation to grow the more profitable commercial property book.
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