The Nature of Activity-Based Costing
Activity-based costing is a simple concept which can provide accurate information about a particular product’s consumption of overhead resources. ABC is an approximation of a user’s fee. A user’s fee refers to the process of charging for service consumed by users of the service. ABC is based on the premise that if a product consumes many resources (activities) that comprise overhead, it should bear a greater share of overhead costs than another product that does not consume as many activity units. In other words, activity costing is almost like riding a city bus. The more you ride, the more tickets you need to buy.
ABC has several advantages, the most important of which is that it forces management to think in terms of simplifying operations. Once activities that are consumed by a product are identified, the process can be evaluated with a view to cut costs. In activity costing management reduces transactions (e.g. handling) which ultimately reduce total cost. This reverses the cycle of the traditional costing where to reduce costs per unit the firm produces more units without regard for inventory management consequences.