This document provides an overview of Activity Based Costing (ABC) in 7 phases: 1. Determine cost objects like products, customers, markets. 2. Group cost objects and develop process maps to understand cost flows. 3. Identify overhead and direct costs like salaries, facilities, shipping. 4. Map costs to cost pools and assign drivers like units produced, orders placed. 5. Allocate pool costs to cost objects using the assigned drivers. 6. Verify the economic logic of the cost assignments for accuracy. 7. ABC provides more accurate profitability analysis by customer than traditional methods.

1. Business Framework
Activity Based Costing
Activity Based Costing (ABC) analysis is a methodology
for assigning costs to those activities that truly drive these
costs. It is more accurate than traditional costing
methods. ABC is an invaluable tool for making strategic
decisions, as it allows you to develop a picture of true
profitability of product lines, customer segments,
geographies, distribution channels, and other markets.
This document explains a 7-phase approach to ABC.
General Ledger (Cost Centers)
Resource
Cost Pool
1
Resource
Cost Pool
2
Resource
Cost Pool
3
Resource
Cost Pool
4
Activity Cost
Pool A
Activity Cost
Pool B
Activity Cost
Pool C
Markets Geography
Distribution
Channel
Products Customers
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2. 3
Contents
• Overview
- Comparison with Traditional Costing Methods
- Advantages and Drawbacks
• Approach
- Overview
- 7 Phases
• Example

3. 5
Activity Based Costing provides tangibly more accurate costs than
traditional costing methods
Comparison between ABC and Traditional Costing Methods
Activity Based Costing (ABC) Traditional Costing Methods
• ABC seeks to correctly assign both direct and indirect
costs to the appropriate cost object (e.g. products,
customers, geographies, markets, channels)
• Traces direct costs correctly to the identified cost
objects
• Attempts to correct the misallocation of overhead
costs by directing them to the correct cost objects
• ABC is of greatest use when overhead costs are a
significant component of total cost
• Traditional costing methods result in inferior cost
estimates
• Direct costs are traced back to those products that
cause cost
• Indirect costs are spread across all products based on
a standard, volume-based cost driver (e.g. labor
hours, weight of raw material, machine hours)
• Traditional costing methods overlook product-specific
R&D, advertising, distribution/channel, and administration
costs
• As a result, there is no way to capture different behaviors
tied to specific customers or products

4. 7
ABC ensures fact-based strategic decisions
ABC Advantages
Activity Based Costing ensures you make fact-based strategic business decisions.

ABC is useful for more accurate strategic decisions in complex, high overhead environments, since
strategic decisions require costs estimates by product or customer

ABC allows fact-based, profit-oriented decisions to be made (e.g. significant fraction of a firm’s
customers might actually be unprofitable, even though the overall firm may be profitable)

ABC can facilitate decisions at the “cost object” level (e.g. drop a product line; don’t serve costly
segments), at the behavioral / operational level (e.g. institute minimum order quantities; change batch
sizes), and at the process level (e.g. improve processes, reduce cost per setup or cost per order)

ABC can be used in benchmarking and process improvement, as well as “direct-setting” and
performance measurement regarding products, channels, and customers

ABC can be used as a financial analysis tool to help value alternatives, which have been identified
through other means (e.g. incremental costs of adopting a differentiation strategy, making near-custom
products for its customers)

5. 9
Contents
• Overview
- Comparison with Traditional Costing Methods
- Advantages and Drawbacks
• Approach
- Overview
- 7 Phases
• Example

6. 11
Phase 1
Determine the primary “cost objects” under analysis
Phase 1 – Overview
Develop
Cost
Objects
Group
Cost
Objects
Develop
Process
Maps
Identify
Cost
Elements
Map GL
Costs
Allocate
Costs
Verify
Economi
c Logic
• In ABC analysis, the first step is always to determine what the primary cost objects are
• A cost object is defined as any end item to which activity costs are assigned and accumulated
• These include products, customers, markets, geographies, and distribution channels
• Cost objects represent logical separations in the costs of the business
• When picking cost objects, it is important to keep them MECE (mutually exclusive and collectively exhaustive)
COST OBJECT CATEGORY EXAMPLES
Products  Product X, Product Line Y, Product Category Z
Customers  Various ways to define customer groups
Markets  Various ways to define markets
Geographies  Countries (e.g. US, China); Regions (e.g. EMEA, APAC)
Distribution Channels  Direct, Indirect, Physical, Online

7. 13
Phase 3
Develop high level process flow maps
Phase 3 – Overview
Develop
Cost
Objects
Group
Cost
Objects
Develop
Process
Maps
Identify
Cost
Elements
Map GL
Costs
Allocate
Costs
Verify
Economi
c Logic
• To create process maps, first, define all major steps required to produce, market, sell, and deliver the products or
services to the customer
• These steps are your process steps
• The concept behind this exercise is to understand how costs flow through the organization to the customer
• It may be helpful to utilize a high-level value chain diagram or the company’s supply chain when conducting this
analysis
• Next, identify primary activities associated with each process step:
• Activities as ―primary‖ have a significant impact on the cost of that process step
• These activities should be defined at a relatively high level (e.g. customer order is taken, order is processed, order
is shipped)
• This information can be developed through interviewing people performing the various functions involved in the
process
It’s important to manage scope when defining process
activities, so that you don’t get mired in creating overly
complex and detailed process flow maps
1
2

8. 15
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Cost item $XX
Phase 4
(cont.)
Phase 4 – Visual Representation & Overhead/GL Cost Detail
General Ledger (Cost Centers)
Resource
Cost Pool
1
Resource
Cost Pool
2
Resource
Cost Pool
3
Resource
Cost Pool
4
Activity Cost
Pool A
Activity Cost
Pool B
Activity Cost
Pool C
Markets Geography
Distribution
Channel
Products Customers
• Sources of information for detailed costs will include
financial systems, financial reports, interviews with key
personnel, division or department P&L statements, and
divisional budgets
• If detailed cost is unavailable, generic overhead
categories can be used to allocate indirect costs to cost
objects
• Insights generated by generic overhead allocation
approach will have less strategic level
• However, this level of detail may be sufficient for the
strategic question under analysis
• Understanding the specific components of
overhead/general ledger costs helps identify the drivers
to these costs
• Overhead/GL costs include the following:
• Salaries, wages, fringe benefits, SG&A, payroll taxes,
processing, marketing, support, accounting, facilities,
utilities, telecommunications
• Other homogeneous-type costs
Develop
Cost
Objects
Group
Cost
Objects
Develop
Process
Maps
Identify
Cost
Elements
Map GL
Costs
Allocate
Costs
Verify
Economi
c Logic

9. 17
Phase 5 – Visual Representation
Phase 5
(cont.)
General Ledger (Cost Centers)
Resource
Cost Pool
1
Resource
Cost Pool
2
Resource
Cost Pool
3
Resource
Cost Pool
4
Activity Cost
Pool A
Activity Cost
Pool B
Activity Cost
Pool C
Markets Geography
Distribution
Channel
Products Customers
Develop
Cost
Objects
Group
Cost
Objects
Develop
Process
Maps
Identify
Cost
Elements
Map GL
Costs
Allocate
Costs
Verify
Economi
c Logic
Resource Cost Pool
• You do not need to create a large, detailed breakdown of
resource cost pools
• Usually 4-7 is sufficient
• One way to form logical groupings of resources into
resource cost pools can be to look at the company’s
value chain or supply chain
Resource Driver
• Resource drivers can take on many forms: e.g.
• Headcount, actions taken, quantity of products, etc.
• One way to determine the true drivers is by asking the
process/activity owner to identify their key resource
drivers
Activity Cost Pool
• An activity cost pool should be identified for each activity
(as defined in Phase 3)

10. 19
Phase 6 – Visual Representation & Insurance Company Example
General Ledger (Cost Centers)
Resource
Cost Pool
1
Resource
Cost Pool
2
Resource
Cost Pool
3
Resource
Cost Pool
4
Markets Geography
Distribution
Channel
Products Customers
Activity Cost
Pool A
Activity Cost
Pool B
Activity Cost
Pool C
EXAMPLES (FOR AN INSURANCE COMPANY)
Overhead/General
Ledger Cost Items
Resource
Cost Pools
Cost Objects
Activity Drivers
Resource Drivers
Activity Cost Pools
• Salaries and wages
• Fringe benefits
• Facilities/ease costs
• Other O/GL costs
• Utilities costs
• Payroll related expenses
• Facilities related expenses
• Processing related expenses
• Other expenses
• FTE count
• Claims processing
• Benefit investigation
• Phone inquiries
• Written inquiries
• Number of claims processed
• Health insurance by US state
• Dental insurance by US state
• Home insurance by US state
• Auto insurance by US state
Develop
Cost
Objects
Group
Cost
Objects
Develop
Process
Maps
Identify
Cost
Elements
Map GL
Costs
Allocate
Costs
Verify
Economi
c Logic
Phase 6
(cont.)

11. 21
Phase 7
Verify the economic logic of the resulting ABC analysis
Phase 7 – Overview
Develop
Cost
Objects
Group
Cost
Objects
Develop
Process
Maps
Identify
Cost
Elements
Map GL
Costs
Allocate
Costs
Verify
Economi
c Logic
• After the profitability results of the ABC analysis have been completed, you should perform a sanity check on the results
• Ask the probing questions …
Does it make sense that those customers, products, and other cost objects that
appear profitable (per the ABC results) are actually doing well?
Conversely, does it make sense that those customers, products, and other cost
objects that appear unprofitable are actually doing poorly?
• If the answer to these types of questions is ―no,‖ you should review the resource and activity drivers to determine if
they are accurate
• Additionally, look for reasonable explanations as to why the ABC results turned out the way they did during the
sanity check

12. 23
Let’s walk through an example where we evaluate the financials of a
manufacturer of “Gadgets” and “Gizmos”
Financials Overview
COMPANY BACKGROUND INFO / FINANCIALS
 The company carries 2 products:
– Gadgets, with an annual volume of 200 units
– Gizmos, with an annual volume of 1,000 units
Income Statement
Revenues $2,500
Cost of gadgets/gizmos $400
Wages/salaries/benefits $1,000
Delivery/freight $400
Overhead $400
Total Costs $2,200
Profits $300
CUSTOMER FINANCIALS
 The company has 3 customers: Rick, Ron, and Randy
 The 3 customers have different purchase volumes and
product prices
Customer
Gizmos Gadgets Revenu
eVolume Price Volume Price
Rick 200 $1.40 10 $12.00 $400
Ron 700 $0.55 140 $8.00 $1,505
Randy 100 $1.60 50 $8.70 $595
SIMPLE PROFIT ANALYSIS
Total Cost $2,200
Total Units 1,200
Unit Cost $1.833
Rick Ron Randy
Revenue $400 $1,505 $595
Units 210 840 150
Cost $385 $1,540 $275
Profit $15 ($35) $320
Our simple
analysis shows
that we are
making a nice
profit from Randy,
but not on the
other 2 customers

13. 25
From the allocation and total costs, we can determine the cost for each
activity
Activity Costs by Management Accounts
Order Taking Manufacturing Packaging Delivery Customs
Cost of Gadgets/Gizmos 0 $400 0 0 0
Wages, salaries, benefits $500 $250 $200 0 $50
Delivery, freight 0 0 $120 $280 0
Overhead
 Facilities $40 $100 $40 0 0
 Insurance 0 $60 $20 $20 0
 SG&A $80 $20 $20 0 0
MANAGEMENT ACCOUNTS
ACTIVITIES COST ($)
= $400
= $1000
= $400
= $180
= $100
= $120
Total Cost Per Activity $620 $830 $400 $300 $50 = $2,200
Total Cost of
Sales (CoS)

14. 27
With unit cost values, we can derive product profitability
Product Profitability
Order Taking Manufacturing Packaging Delivery Customs
ACTIVITIES COST ($)
Gadget $387.50 $730 $125 $150 $25
Gizmo $232.50 $100 $275 $150 $25
PRODUCTS
Revenue Cost Profit Unit Cost Unit Profit
Gadget $1,675 $1,417.50 $257.50 $7.09 $1.2875
Gizmo $825 $782.50 $42.50 $0.78 $0.0425
PRODUCTS
Assume 125 orders
of Gadgets, 75
orders of Gizmos
Assume each
packaged Gadget
weighs 2.5 lb, each
packaged Gizmo
weighs 0.5 lb
Assume 10
packages each of
Gadgets and
Gizmos went
through customs
Gadget is
significantly
more
profitable than
the Gizmo
PROFITABILITY SUMMARY ($)

15. 29
… However, Activity Based Costing provides the most accurate customer
profitability analysis
Activity Based Customer Profitability
Driver Unit Cost Rick Ron Randy
Order taking Number of calls 50 75 75
Manufacturing Gadgets manufactured
Gizmos manufactured
10
200
140
700
50
100
Packaging Gadgets packed
Gizmos packed
10
200
140
700
50
100
Delivery/freight Weight (in pounds) 125 700 175
Custom # of packages through customs 0 0 20
ACTIVITY USAGE
Order taking Number of calls $3.10 $155 $232.50 $232.50
Manufacturing Gadgets manufactured
Gizmos manufactured
$3.65
$0.10
$36.50
$20
$511
$70
$182.50
$10
Packaging Gadgets packed
Gizmos packed
$0.63
$0.28
$6.25
$55
$87.50
$192.50
$31.25
$27.50
Delivery/freight Weight (in pounds) $0.30 $37.50 $210 $52.50
Custom # of packages through customs $2.50 $0 $0 $50
ACTIVITY FINANCIALS
Total Cost $310.25 $1,303.50 $586.25
Revenue $400 $1,505 $595
Profit $89.75 $201.50 $8.75
Final customer profitability
is drastically different from
initial analysis