Activity-Based Costing

Activity-Based Costing (ABC) arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods. The traditional cost accounting methods were designed around 1870 - 1920 and in those days industry was labor intensive, there was no automation, the product variety was small and the overhead costs in companies were generally very low compared to today. However, from the 1960s - particularly 1980s - this changed rapidly. For these reasons, and more, traditional cost accounting has been called everything from 'number 1 enemy of production' and questions whether it is 'an asset or a liability' have been raised.

The question of course is whether ABC has overcome these deficiencies or not? It has. In fact, ABC has been called one of the most important management innovations the last hundred years.

So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there is three major differences:

In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities.

Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.

Traditional cost accounting is structure-oriented whereas ABC is process-oriented.

This is discussed in more detail in the subsequent sections and illustrated below.

But first, the direction of the arrows are different because ABC brings detailed information from the processes up to assess costs and manage capacity on many levels whereas traditional cost accounting methods simply allocate costs, or capacity to be correct, down onto the cost objects without considering any 'cause and effect' relations