Activity-Based Costing (ABC) in a Small Firm - dummies

Activity-Based Costing (ABC) in a Small Firm

By Stephen L. Nelson

Here are three important observations about ABC in a small firm. Some of this stuff is obvious, and some of it is redundant. However, it’s important enough for you hear it at least one more time:

  • ABC is most useful when you have lots of overhead and a bunch of 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 may sometimes be the case in a small firm. (Keep reading, though, because analysis of cost drivers can provide one unique insight.)

  • ABC may not make sense for custom manufacturing environments. In a custom manufacturing environment — this is any business in which 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’s the big benefit of ABC.

    ABC is first and foremost a tool for better allocating overhead costs.

  • Cost drivers “drive” costs. For example, in the discussion of the hot dog stand business and the activity labeled serving a customer, the serving steps are the cost drivers. The number of steps required to serve a customer drive the costs 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.

    Suppose that instead of spooning three heaping tablespoons of chili onto a chili dog, you purchase one spoon equivalent to three tablespoons; this would change the number of steps from five to three. Recall the original, five-step approach to serving the chili dog customer:

    1. Grab a hot dog bun.

    2. Slide a hot-off-the-grill frankfurter into the bun.

    3. Ladle a heaping tablespoon of chili into the bun.

    4. Ladle another heaping tablespoon of chili into the bun.

    5. Ladle a third heaping tablespoon of chili into the bun.

    If you get a three-tablespoon spoon, you can simplify the serving of a chili dog into three steps:

    1. Grab a bun.

    2. Slide a hot dog into the bun.

    3. Heap a three-tablespoon serving of chili into the bun.

    Changing the number of steps required to serve a customer a chili dog changes the cost of the serving activity for a chili dog. And changing the cost of serving a chili dog changes the profitability (potentially) of serving a chili dog.

    “Potentially” because you may not actually be able to reduce your wages expense by buying a three-tablespoon spoon for lathering up your chili dogs 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.

The bottom line concerning ABC is this: ABC lets you better allocate overhead costs, and as a bonus, ABC 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.