ABC: The Next Generation

Activity-based costing (ABC) is a method of allocating expenses through analysis of activities, as opposed to the conventional approach of using bookkeeping accounts. A decision-making approach based on ABC is referred to as activity-based management (ABM). ABC and ABM developed from observations that traditional cost-accounting methods do not always provide useful guidance to managers in operations. In fact, they can consistently reward managers for making less-than-optimal or economically wasteful decisions.

Companies embrace ABC to better understand their real product costs and true customer profitability. It plays a role in developing pricing strategies, understanding make-or-buy decisions, and identifying and measuring process improvement initiatives. ABC was presented initially in 1986 by business professors Robin Cooper and Robert Kaplan in describing how traditional cost accounting can systemically distort product costs. ABC borrows from German alternative cost-accounting efforts known as GPK, which began in the 1960s. GPK is a marginal cost analysis approach that focuses on operational cost and resources consumed rather than financial accounting.

Many U.S. companies jumped on ABC in the early 1990s because there was a broad though tacit understanding that cost accounting could lead to bad management decisions, especially in manufacturing. Results of these efforts to adopt ABC were mixed at best, though. By some estimates, 60 percent of larger companies in the United States tried it initially but only one in five sustained it for more than five years.

It proved not to be easy to make the transition from case studies to workable solutions. Companies stumbled over issues ranging from cultural resistance to information and technology challenges. (German companies have been much more successful in using GPK, largely because it fits better with their business practices and culture and because it integrates the measurement and management of the business into the accounting system.)

Over the past five years, however, an increasing number of companies in the United States have taken fresh approaches to ABC/ABM, with better results. Some of the reasons for improved use of activity-based costing lie in avoiding past mistakes. In addition, several books have built on lessons learned, including Activity-Based Management: Arthur Andersen's Lessons from the ABM Battlefield (Wiley, 2nd Edition, 1999), edited by Steve Player and David Keys, and a fresh approach authored by Robert Kaplan and Steven Anderson, Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits (Harvard Business School Press, 2007), aimed at decreasing the amount of effort required to set up the costing system. Moreover, the information and analytics needed to implement ABC/ABM have become more accessible, easier to use, and less expensive to deploy and maintain than they were two decades ago. This has made it much easier to integrate ABC into business planning, a key part of successful ABC implementations.

Many companies that look into changing their costing systems find that they are making mistakes, both large and small, that stem from the systemic failure of their cost-accounting systems to deliver actionable economic intelligence that they can use to optimize production, planning, and sales incentive systems (to name three of the most important areas for improvement). If your company makes anything, and particularly if you have asset-intensive production processes, you should examine activity-based costing (or GPK) to ensure that you are employing your resources most effectively.

See the chart "The Contenders: Software That Flexes ABC Muscle" here.