Should You Use Activity-Based Costing in a Small Business?
Activity-based costing (ABC) lets you better allocate overhead costs and, as an added bonus, also often gives you unique insights into what “drives” your overhead costs. With this information in hand, you can make better decisions about your product and service lines, and sometimes you can even change your business operations in a way that reduces your costs. When considering using ABC in a small business, you’ll want to think about a few things.
ABC is most useful when you have lots of overhead and a bunch of different products. In any environment that doesn’t have a lot of overhead, ABC isn’t worth the work and won’t deliver insights. Likewise, ABC doesn’t make sense in any business that sells a single product or that provides a single service, which is usually the case in a small firm.
ABC may not make sense for custom manufacturing environments. In a custom manufacturing environment — this is any business where you make specific things for specific customers — you can often use job costing to provide good product or service profitability measures. For example, in the case of a single-family home builder, the builder can use job costing to track revenues and expenses by job (single family home). And that job costing may provide the detailed profitability-by-product-line information that is the big benefit of ABC. Remember, ABC is first and foremost a tool for better allocating overhead costs.
Cost drivers “drive” costs. The number of steps required to serve a customer drives the cost of serving the customer. That may sound really dumb, but sometimes one of the benefits that ABC provides is an insight into how changing the number of cost drivers changes your costs. For example, suppose that instead of spooning three heaping tablespoons of chili onto a chilidog, you purchase one spoon equivalent to three tablespoons; this would change the number of steps from five to three.
Changing the number of steps required to serve a customer a chilidog changes the cost of the serving activity for a chilidog. And changing the cost of serving a chilidog changes the profitability (potentially) of serving a chilidog. I say “potentially” because you may not actually be able to reduce your wages expense by buying a three-tablespoon spoon for lathering up your chilidogs with chili, but you get the idea.
Note: To really save money by reducing the number of steps, you need to be able to cut your wages expense.