Executive Summary
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Traditional cost allocation methodologies in firms can provide misleading information about the profitability of products, product lines, customers, and markets.
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Activity-based costing (ABC) provides more meaningful information about the drivers of costs, the activities performed in a firm, and the relationship between costs and products, customers, markets, and segments.
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In addition to supplying more detailed and better cost and profitability information, an ABC analysis enables managers to evaluate processes from an activity viewpoint, leading to identification of non value-adding activities and process inefficiencies.
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ABC does not change overall profitability in a firm; it better aligns cost assignment to the causes of those costs.
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With better information, better decisions can be made in a firm to improve profitability—this is the power of ABC.
Introduction
Cost allocation in firms can provide misleading information about the profitability of products, product lines, customers, and markets. Traditional cost allocation practices allocate all manufacturing overhead costs using a single driver such as direct labor hours, direct labor dollars, or machine hours. Sales-related costs are typically ignored. While technically accurate, in most complex organizations a single overhead cost driver is not sufficient to accurately assign the pool of overhead costs to the products that are being produced or the customers that are being served.
Many firms—from manufacturing to medical and healthcare to banking and financial services to hospitality and not-for-profit organizations—have benefited from designing and implementing ABC allocation systems. Using ABC tools has helped these organizations to understand profitability more clearly, and has provided meaningful information about processes and costs associated with delivering goods and services. A well-designed and implemented ABC system is a powerful aid to management evaluation and decision-making, thereby improving organizational performance.
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