Activity-based cost management is an accounting method used by companies which allocates overhead costs for each activity based on the specific circumstances of each activity. This is in contrast to the common method of allocating costs based solely on the hours spent manufacturing a product or catering to a specific customer. The main advantage of activity-based cost management is that it provides a truer representation of the worth of each specific activity conducted by a business, thus reducing wasteful overhead costs. It can be a difficult process to implement, but, used effectively, can save a company a significant amount of money.
As a business grows, the costs of maintaining and operating that business usually grow in kind. When these costs grow, companies must have accounting practices in place to allocate the necessary funds for each specific business activity. These activities can include either the manufacturing of a specific product or the cultivation of a specific client. By using activity-based cost management, a company can separate these activities according to the actual costs incurred and their importance in the company's operations.
For example, imagine a company that has to account for the manufacturing of two specific products. Product A is produced at low cost but at a high volume, meaning that a lot of hours are spent on it. On the other hand, Product B is only rarely produced, but it requires a great deal of technical expertise and it costs the company a significant amount to produce a single unit. A traditional accounting approach might allocate more overhead to Product A based on the amount produced and the time spent. Activity-based cost management would account for the fact that Product B requires a much-more cost-intensive approach and would allocate costs for it accordingly.
In the same manner, a company that serves clients in some manner can also allocate costs accordingly based on activity-based cost management. Imagine a law firm dealing with many clients that pay less in retainer fees but require more man hours of labor than a few high-paying clients that only call on the firm in rare occasions. An activity-based approach would see the worth of the higher-paying clients, since the man hours spent serving them might not represent the costs associated with that time.
Some companies shy away from activity-based cost management because it can be a much more intricate process that simply divvying up overhead based on the hours spent on an activity. Several well-known international companies have benefitted from this approach though, saving on overhead costs in the process. Software programs devoted to activity-based allocation of costs can make implementation the technique a bit easier.