Beneath The Surface

Activity-based costing showed up on the business scene in the early 1980s, largely through the writing of Harvard Business School professor Robert S. Kaplan. Driving the interest in ABC was the growing proliferation of products and segmentation of customers and markets, along with generally tougher competition, says Cokins.

"Kaplan realized that accountants were using a single factor to assign cost to products," Cokins says. "It was usually labor hours, or sometimes gallons or pounds. When product diversity increased, this became nonsensical. Some things inevitably got over-costed, and others got under-costed relative to their true consumption of costs."

Today, ABC is considered particularly useful to companies with diverse products, many types of customers and tough competition. Firms in industries experiencing rapid price reductions are also prime candidates.

The first step in applying ABC is to define cost categories. These may include salaries, materials, utilities and the like.

Next, identify primary processes and key activities for each category. For instance, the process of addressing customer help requests involves activities such as answering the phone and researching questions.

Then calculate the costs of each activity by, for example, dividing the number of help requests processed into the combined salaries and benefits of your help-desk workers. Finally, you assign each activity's costs to the appropriate category.

Done right, the ABC exercise accurately assigns the costs of activities done for specific customers, products and services. That can point to activities that waste time. It can also highlight the customers, products and services that are actually keeping you afloat. It's not unusual, say advocates, for ABC to reveal that most of a firm's customers or products are actually losing money.

This article was originally published in the October 1999 print edition of Entrepreneur with the headline: Beneath The Surface.