IT Financials Glossary

ABC (Activity-Based Costing)

Posted in Costs by mgentle on August 26, 2010

ABC (Activity-Based Costing): a method for assigning costs to products and services based on the activities required to produce them. Knowing how much products and services really cost allow companies to justify expenditure, identify what’s profitable vs unprofitable and explore opportunities for cheaper alternatives.

ABC is best understood via an example. Let’s imagine a customer service department in a Business-to-Business (B-to-B) telco with a team of multi-skilled call centre agents who handle both external customer enquiries and internal enquiries from the sales force. In addition, they correct orders that have wrong or missing information by calling the customers and doing it on the phone.

You build an ABC model by first interviewing the agents and asking them how much time they spend on these three activities, which they estimate at 60%, 30% and 10% respectively (for simplicity’s sake we will avoid breaking down these activities into “cost pools”). You then count the number of “cost drivers” – ie, the number of external enquiries, internal enquiries and rejected orders – which for our example is say, 10 000, 2 500 and 1 000 per year respectively. Finally you factor in the total costs of the department, which are $1m per year.

This data is then entered into a model in an ABC system, which calculates the following activity cost driver rates (Fig. 6.1 below – NB click on the image to get a full-screen view):

An example of Activity-Based Costing

Needless to say, this simplistic example hides a number of inaccuracies and complexities, the main ones of which are:

  • The time spent is based on people’s subjective estimates of their behaviour – and assumes 100% annual productivity, with no idle time.
  • Any changes in activities and processes due to new or changed products, or to exception processing, would require re-interviewing and maintenance of the model.
  • If the approach were applied to 100 people instead of only three, and across multiple activities more complex than those for a call centre, the effort and cost involved in interviewing people, setting up the model and maintaining it could soon become prohibitive.
  • If required, as in IT, it would be difficult to break down people’s activities into capex and opex.

The conclusion is that ABC is more suited to relatively stable, industrial, commodity-type processes with little exception processing. It would also need to be a high-volume activity to justify the overhead of maintaining an ABC system.

Even in a stable industrial environment, the above constraints can still become a barrier to ABC, which has led the inventors of the original model, Robert S. Kaplan and Steven R. Anderson, to propose in 2003 a simplified version called time-driven ABC (see “Further reading” in Appendix 2).

Needless to say, IT projects do not correspond to this type of environment. The most common method for evaluating people costs in a project is through time-entry. ABC in IT is therefore only really applicable to stable production applications and services.

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