Lean Term: Activity-Based Costing

The definition of Activity-Based Costing: a means of attempting to accurately apply costs of running a business to a specific product or service. It entails identifying the ‘cost drivers’, or the things that drive the consumption of shared resources, and using them to apply a logical proportion of overhead costs to specific products.

In traditional costing methods, overhead may be applied by a broad brushstroke. All overhead costs may be applied, for example, at the same ratio as the ratio of direct labor costs. The danger of this method is that one product may, in effect, subsidize another product that uses resources in a different manner. In some cases, this may simply skew the understanding of how much profit each product contributed. In other cases, the incorrect allocation of costs may actually make an unprofitable product group appear profitable.

As an example, one product may use a significant footprint (floor space) of a factory, yet have a relatively low number of direct labor employees building the product. As a result, the applied overhead may be charged at a much lower rate than it should be (using traditional methods). In effect, the product would be getting free rent, electricity, etc., making its cost structure appear better than it really is. (Activity-Based Costing would account for the specific drivers that add cost.)

Obviously, the danger is that this incorrect understanding of the nature of the company’s profitability may drive poor decisions. For example, managers may focus on growing an unprofitable product line, or use faulty assumptions for a capital equipment purchase.

Having a good understanding of costs is critical to properly applying limited continuous improvement resources. If you don’t know where the trouble spots are, how can you eliminate them?

OK, you’re sold, right? Not so fast. There is a down-side. It is much harder to manage. First of all, the cost drivers have to be identified, then quantified, and then applied. And, of course, as your process improves, the floorspace goes down. So, the cost drivers have to be managed. And the reported information has to be reconciled so it comes out correctly (i.e. the floorspace has to add up to the size of the facility).

Managers may also end up arguing over who used the aisle way more, or what cost drivers should be used to divvy up a call center. It gets even murkier when there is not a clear dividing line for costs. It may be hard to apply the costs of awareness building advertising to a specific product line. For example, how are the costs of an ad for a car manufacturer applied if the ad features several cars in it? The point: there’s extra cost in managing more costs.

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