BH058

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Activity-based Costing for

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the Small Business: A Primer

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Sidney J. Baxendale

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U nderstandably, entrepreneurs and own-
ers of small firms are not likely to give
much thought to an accounting system
during the planning or implementation phases of
It is based on the
assumption that
as a product is
manufactured, it If accurate product
their business. The business plan forces them to absorbs the costs costing, more flexible
deal with pro forma financial statements that are of the direct ma-
properly integrated to assist bankers and venture terials that be- capacity use, and better
capitalists in evaluating the venture. come a part of it,
information for strategic
op
Soon after start-up, however, these entrepre- the labor used in
neurs and small business owners will be faced making it, and planning and decision
with the need for an accounting system to meet the overhead
the ongoing information needs of the investors, costs associated making appeal to you,
the lenders, and the various authorities that will with its produc- ABC is the supplement
tax the income of the business. An accounting tion, which in-
system that meets those needs is one that is gov- clude deprecia- to use with traditional
erned, to a great extent, by the demands of the tion on the ma-
accounting methods.
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Financial Accounting Standards Board (FASB), in chinery and the

the case of information provided to investors and
lenders, and by the Internal Revenue Service, in
the case of information provided for income tax
purposes.
Accounting systems designed to meet the
needs of investors, lenders, and income taxing
authorities often fail to provide the managerial
accounting information necessary to operate the
No
facilities, supervi-
sory costs, heat and electricity, and many other
costs related to operating the firm. The assump-
tion behind absorption costing is that these ex-
penses are necessary for the product to be manu-
factured, so each should attach itself to, or be
absorbed by, the product being manufactured.

new venture. In particular, they do not provide
the information needed to accomplish the very
important tactical and strategic planning and
decision making that will be critical to success.
Traditional Accounting Systems
The term “traditional” is used to describe the ac-
counting system designed primarily to meet the
needs of investors, lenders, and income tax au-
thorities. Such a system is characterized by absorp-
Do
Absence of Marketing and Distribution Costs
in Product Costs
Using absorption costing, the product costs in-
clude only the costs of manufacture, not those of
marketing and distribution. Traditional accounting
regards marketing and distribution costs as hav-
ing been expensed during the accounting period
in which the costs are incurred, rather than in-
cluding them in the cost of items in the ending
inventory. Thus, if the entrepreneur or small busi-

Business Horizons
tion costing. Absorption costing takes its name ness owner were to ask the accountant for the Copyright © 2001
from the manner in which inventory is valued for cost per unit of each type of product made, the by Indiana University
reporting on the balance sheet and the cost of accountant’s answer would most likely be ex- Kelley School of
goods sold is valued for reporting in the income pressed in terms of absorption costing and would Business. For reprints,
call HBS Publishing
statement—in other words, the manner in which include only manufacturing costs. The omission at (800) 545-7685.
products “absorb” cost as they are manufactured. of marketing and distribution costs could be par-

Activity-based Costing for the Small Business: A Primer 61

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 t
ticularly misleading if they run high compared to uct costing by allocating fixed marketing and

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a product’s manufacturing costs. The cost profile fixed distribution costs to products based on the
of many consumer products includes marketing relative sales dollars contributed by each product.
and distribution far in excess of the cost of mak- However, that method assumes that the market-
ing the product. Such could easily be the case for ing and distribution effort associated with each
mass-market convenience products, such as product is appropriately measured by the prod-
foods, health care items, and so on. uct’s sales—an assumption often revealed to be
Some companies have dealt with the omis- inappropriate. Newly introduced products often

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sion of marketing and distribution costs in prod- have low sales volumes but require intensified
marketing and distribution efforts. Standard, high-
volume products may not require a commensu-
Table 1 rate marketing and distribution effort.
Material Costs and Machining Time Per Unit of Product
The Distortion Caused by Absorption Costing
Product P Product Q
Direct Material Costs $45.00 $40.00 The manner in which manufacturing overhead
Machine A 15 minutes 10 minutes attaches itself to the product also causes distor-

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Machine B 15 minutes 30 minutes tions in product costing. Unlike direct material
Machine C 15 minutes 5 minutes costs, which tend to vary in direct proportion to
Machine D 15 minutes 5 minutes the number of units manufactured, factory over-
Total Machine Time Per Unit 60 minutes 50 minutes head is most often a fixed cost. Manufacturing
overhead is incurred in the form of depreciation
Adapted from Goldratt (1990) expense or supervisory salaries. If production
volumes are lower in one accounting period,
Table 2 manufacturing overhead is not likely to be low-
Calculation of Product Costs When 100 Units of P ered commensurately, or even at all. This inclu-
op
and 30 Units of Q Are Produced sion of both direct costs (direct materials) and
fixed costs (factory overhead) causes a product
Factory overhead costs per week: $6,000 costing distortion that has the potential of mis-
leading an entrepreneur or owner/manager trying
Machine hours used per week:
100 units of P @ 60 minutes per unit = 6,000 minutes to run a small business.
30 units of Q @ 50 minutes per unit = 1,500 minutes On the other hand, if the owner of a small
Total minutes 7,500 minutes/week service firm were to ask the accountant for the
cost per unit of each type of services produced,
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Cost per machine hour $6,000 / 7,500 minutes = 80¢ per minute
the accountant would probably be at a complete
Product P Product Q loss as to how to respond. This is true because
Raw Materials $45.00 $40.00 service firms typically have no cost accounting
Machine A at 80¢ per minute 12.00 8.00 system to attribute costs to each of the various
Machine B at 80¢ per minute 12.00 24.00 services provided.
Machine C at 80¢ per minute 12.00 4.00 To demonstrate the distortion caused by ab-
Machine D at 80¢ per minute 12.00 4.00 sorption costing, it is necessary to use a simple
Product Cost Per Unit $93.00 $80.00 example in which a new venture manufactures
two products using four different machines. The
No

Table 3 cost of raw materials for each product and the

Calculation of Product Costs When 80 Units of P amount of time each product requires of each
and 24 Units of Q Are Produced machine are indicated in Table 1.
We shall assume further that the costs associ-
Machine hours used per week: ated with the factory are $6,000 per week and
80 units of P @ 60 minutes per unit = 4,800 minutes include the wages of the machine operators, the
24 units of Q @ 50 minutes per unit = 1,200 minutes depreciation on the machines and buildings,
Total minutes 6,000 minutes/week supervisor salaries, and the electricity to power
Cost per machine hour: $6,000 / 6,000 minutes = $1.00 per minute the machines. The $6,000 weekly cost will be
absorbed by the products that are produced dur-
Product P Product Q ing the week.
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Raw Materials $45.00 $40.00 Using the simplest basis of cost allocation,
Machine A at $1.00 per minute 15.00 10.00 the $6,000 of fixed overhead costs could be allo-
Machine B at $1.00 per minute 15.00 30.00 cated to the products based on the number of
Machine C at $1.00 per minute 15.00 5.00 units produced during the week. If Product P
Machine D at $1.00 per minute 15.00 5.00
accounted for 75 percent of the number of units
Product Cost Per Unit $105.00 $90.00
produced, 75 percent of the $6,000 would be

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allocated to it. However, an allocation of the
factory overhead costs based on units of produc-
tion could be distorting because Product P uses
60 minutes of machine time compared to 50 min-
utes for Product Q. Thus, an allocation of factory
costs based on machine time is likely to result in
a more equitable allocation of costs between the
two products using absorption costing.
Table 2 shows the calculation of product
costs for Products P and Q using this method of
allocation, assuming that 100 units of P and 30
units of Q are made each week. The absorption
cost is $93 per unit for Product P and $80 per
unit for Product Q. However, if the weekly pro-
duction were 80 units of Product P and 24 units
of Product Q, the cost per unit would be as
shown in Table 3. A comparison of Tables 2 and
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3 shows that when the number of units produced
decreases while the fixed overhead costs remain
unchanged, the cost per unit increases. In this
example, when the unit production of Product P
decreased by 20 units per week, the cost per unit
increased from $93 to $105. A six-unit decrease in
Product Q resulted in a cost per unit rise of $10.
Absorption costing, then, causes the cost per
unit to fluctuate as the production level changes.
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If the number of units produced increases, the
cost per unit decreases, and vice versa. This fluc-
tuating cost can frustrate those attempting to co-
ordinate marketing and production. Given a fixed
selling price, the fluctuating product cost from
one accounting period to the next would make it
difficult to develop marketing strategies for pric-
ing and promotion. A product that seemed profit-
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able in one accounting period when production
was high could be unprofitable in another period
with a decline in production.
Turney (1991) calls this problem the “death
spiral.” As marketing finds that products are un-
profitable on a per unit basis, it may attempt to
raise the price in order to improve profitability.
Of course, the higher price in a competitive mar-
ket causes the demand for the product to decline
No
even more. The lower production, in the face of
unchanging overhead costs, causes the product
to become even less profitable. When carried to
the extreme, this results in the firm’s demise.
The death spiral aspect of absorption costing
has become more of a threat as a greater portion
of manufacturing costs have become fixed. Auto-
mation, technology, and the use of knowledge
workers rather than production laborers have
contributed to a manufacturing situation charac-
terized as capital- rather than labor-intensive. As
Do
fixed manufacturing overhead has become the
dominant portion of product costs, the impact of
varying production levels on product costs has
been magnified. Now only a slight change in pro-
duction level can result in a large change in per-
ceived product costs, and thus profitability.
Activity-based Costing for the Small Business: A Primer
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t
The Lack of Cost Accounting in a Service Firm
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Service firms have an even more serious problem
when it comes to product costing. Because they
have no inventories, there are no external forces
such as lenders, investors, or the IRS mandating
an accounting system that yields the cost of ser-
vices. In the absence of this external pressure,
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few have attempted to determine the costs asso-
ciated with each of the services they provide to
the market. As a result, their owners often do not
understand the profitability of each service.
The absence of a cost accounting system in a
service firm is particularly troublesome when one
considers that most of the firm’s costs are fixed
costs that are not directly identified with a par-
ticular service provided. Manufacturing companies
have raw material costs that are directly associ-
ated with a product. But nearly all the costs of a
service firm are incurred to support all the ser-
vices it offers. The lack of direct costs dictates
that any accounting system designed to deter-
mine the cost of each type of service would have
to rely on a method of allocating such costs.
Here is where activity-based costing, or ABC,
comes to the rescue. ABC is a method for allocat-
ing costs to products and services. The example
used here to describe it is based on a manufac-
turing situation. However, the identification of
activities, specification of cost drivers for each
activity, calculation of charging rates for each
activity, and allocation of costs to each product/
service is the same for both manufacturers and
service firms. The same is true for the described
isolation of unused capacity costs.
ABC AS A SOLUTION
A s a result of the trend away from labor
intensity and toward capital intensity,
the cost profile for many industries has
changed dramatically in recent years, and any
new venture will be forced to compete in that
arena. Automation, technology, and computeriza-
tion have lowered the cost of production for
many products, with the result that larger por-
tions of the production costs are fixed. Moreover,
the marketing and distribution costs have now
become a larger part of the total cost of taking a
product from raw materials to consumption. Un-
der these new conditions, the continued use of
absorption costing as a basis for managerial deci-
sions could result in inappropriate actions.
ABC is an alternative that supplements the
absorption costing method required for external
reporting to investors, lenders, and income tax
authorities. It is highly appropriate as a basis for
preparing accounting information intended to be
used in tactical and strategic planning and deci-
sion making for a new business venture.
63
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The charging rates for the other activities are $2.00
Table 4

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per minute for Machine B, 16.666¢ per minute for
Activity-based Costs and Capacities Machine C, and 20.83¢ per minute for Machine D.
Using these charging rates, the ABC product cost
Activity Weekly Cost Weekly Capacity is calculated in accordance with the approach
Machine A $300 2,400 minutes suggested by Kaplan and Cooper (1998) and
Machine B $4,800 2,400 minutes
shown in Table 5.
Machine C $400 2,400 minutes
Machine D $500 2,400 minutes Because the unit product cost is based on the

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Total $6,000
Note: Machine (Activity) B has higher costs relative to
the other machines because it is a very costly machine
that occupies a large portion of the factory. Moreover, it
requires a significant portion of management’s attention.
Table 5
Calculation of Product Cost Using ABC
capacity of the cost driver for each activity, the
cost per unit will not vary as the number of units
produced changes from one period to the next.
This is in stark contrast to absorption costing,
which allocates costs based on total machine
hours used rather than the capacity of each ma-
chine. In addition to the stabilization of unit
product costs, the cost of unused capacity in
each activity will be revealed based on the num-

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ber of unused hours times the charging rate for
each activity. When 100 units of Product P and 30
Resource or
units of Product Q are produced, the cost of un-
Activity Product P Product Q
Raw Materials $45.000 $40.000 used capacity is revealed separately from the cost
Machine A 1.875* 1.250 incurred by the products that were produced.
Machine B 30.000 60.000 The costs associated with those product units are
Machine C 2.500 .833 shown in Table 6.
Machine D 3.125 1.042
Total Cost $82.500 $103.125 The Effect of Isolating Unused Capacity Costs
op
*15 minutes x 12.5¢ per minute charging rate = $1.875 The isolation of unused capacity costs as shown
in Table 6 reveals that Activity B has no unused
capacity, and Activities A, C, and D have some
The weekly fixed manufacturing overhead of unused capacity when 100 units of Product P and
$6,000 used in the earlier calculation of product 30 units of Product Q are produced during the
cost will now be used to illustrate ABC. However, week. Absorption costing folds the unused ca-
that $6,000 will first be traced or allocated to pacity costs into the cost of the product units, but
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each of the four machines (now called “activities”)
in the factory. The depreciation expense associ-
ated with each activity can be determined by
reference to the fixed asset accounting records.
The depreciation on the building can be allo-
cated to each activity based on its appropriate
share of the factory space. The salaries of the
supervisors and other knowledge workers will be
allocated to the activities based on an estimate of
No
ABC isolates them and bases the unit product
costs only on the extent to which each product
makes demands on the various activities.
One result of isolating unused capacity costs
is that the constraining activity is identified. Activ-
ity B is shown to have zero unused capacity. So
if the company were to produce more of either
product, it would have to create some unused
capacity in Activity B. ABC provides the informa-

the amount of time devoted to each activity in
this rather automated manufacturing environment.
Power costs will be identified with each activity
based on engineering estimates. We shall assume
that this tracing and allocating of costs to activi-
ties results in the weekly costs shown in Table 4,
which also indicates the practical capacity of each
activity for one week.
Whereas absorption costing attaches costs to
products based on production volume allocation,
such as actual machine hours devoted to each
Do
tion necessary for focused process improvement.
If the company succeeded in improving the pro-
cess by which Activity B manufactures either or
both products, unused capacity would be created
for Activity B. The isolated unused capacity also
reveals that improving the processes for Activities
A, C, and D without improving that for Activity B
would only create more unused capacity without
being able to produce more of either product.
Such is the nature of the constraint imposed by
Activity B.

product, ABC relies on an allocation base (cost
driver) unique to each activity. In Table 4, notice
that Machine A has a cost of $300 per week and a
capacity of 2,400 minutes per week. Thus, any
product using Machine A should appropriately be
charged 12.5¢ per minute ($300 ÷ 2,400 minutes).
ABC provides focus for process improvement
by identifying the activity in which the improve-
ment effort should be concentrated. Without such
focus, process improvement might either be ig-
nored altogether or be spread across all activities,
whether needed or not.

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 t
Another Advantage of Isolating driver for marketing, and the weekly capacity for

Unused Capacity Costs
In contrast to absorption costing, which results in
unit product costs that vary as production volume
varies—and hence the death spiral—ABC results
in a per unit cost that remains the same in the
face of variations in the quantity produced. Any
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the marketing activity is 20 sales orders. The
number of shipping orders is also the cost driver
for the distribution activity, and the weekly ca-
pacity is 25 shipping orders.
Just as the number of machine (activity) hours
had to be related to each of the products when

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such variations are reflected by changes in the
cost of unused capacity, not unit product costs.
Process improvement is still the focus, and with Table 6
the stabilized unit product cost, the tendency Isolation of Unused Capacity Costs Using ABC
toward the death spiral can be avoided. (100 Units of Product P and 30 Units of Product Q Per Week)
Table 7 shows the unit product cost and
unused capacity costs associated with 80 units of Unused
Product P and 24 units of Product Q. By contrast- Product Product Capacity Total
ing Table 6 with Table 7, notice that the per unit P Q Cost Cost

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costs for Products P and Q are the same under Raw Materials $4,500.00 $1,200.00 --- $5,700.00
Activity A 187.50* 37.50 $75.00† 300.00§
both assumptions concerning weekly production
Activity B 3,000.00 1,800.00 0 4,800.00
quantities. That was not the case when the same Activity C 250.00 25.00 125.00 400.00
contrast was made with absorption costing (Table Activity D 312.50 31.25 156.25 500.00
2 versus Table 3), under which the lower weekly Total $8,250.00 $3,093.75 $356.25 $11,700.00
production resulted in sharply higher unit prod-
uct costs. Another observation is that the lower Product Product
weekly production in Table 7 results in a much Cost Per Unit P Q
higher unused capacity cost, with all machines Raw Materials $45.000 $40.000
op
having unused capacity. Activity A 1.875 1.250
This is important information in developing Activity B 30.000 60.000
Activity C 2.500 .833
product mix decisions and short-term marketing
Activity D 3.125 1.042
plans. Marketing should be made aware of the Total Per Unit $82.500 $103.125
extent to which there is planned unused capacity
to sell. The fact that additional units can be pro- * 100 units x 15 minutes x 12.5¢ charging rate = $187.50
duced without incurring any additional fixed †
$300 – $187.50 – $37.50 = $75.00 cost of unused capacity
overhead costs should encourage marketing to §
$300 is the weekly cost of Activity A
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use special pricing to seek short-term contracts or

intensify its marketing efforts. The isolation of
unused capacity costs provides the information Table 7
needed to understand the significance of trade- Isolation of Unused Capacity Costs Using ABC
(80 Units of Product P and 24 Units of Product Q Per Week)
offs between add-on sales at special prices or no
add-on sales at all.
Unused
Product Product Capacity Total
Marketing and Distribution Costs Using ABC P Q Cost Cost
Raw Materials $3,600.00 $960.00 --- $4,560.00
No

Under absorption costing, the product costs in- Activity A 150.00* 30.00 $120.00† 300.00§
cluded only manufacturing costs, not those of Activity B 2,400.00 1,440.00 960.00 4,800.00
marketing and distribution. ABC, however, recog- Activity C 200.00 20.00 180.00 400.00
nizes the relevance of the latter when cost infor- Activity D 250.00 25.00 225.00 500.00
mation is used in planning and decision making. Total $6,600.00 $2,475.00 $1,485.00 $10,560.00
In a continuation of the example involving
Product Product
Products P and Q, assume that the weekly fixed
Cost Per Unit P Q
marketing costs are $2,000 and the weekly fixed Raw Materials $45.000 $40.000
distribution costs are $1,000. These costs would Activity A 1.875 1.250
likely include personnel expenses, advertising Activity B 30.000 60.000
and promotion, and depreciation on equipment Activity C 2.500 .833
Do

used in distribution. Assume also that the $2,000 Activity D 3.125 1.042
of marketing costs is sufficient for the company Total Per Unit $82.500 $103.125
to generate 20 sales orders per week, and the
$1,000 of distribution costs is sufficient for the * 80 units x 15 minutes x 12.5¢ charging rate = $150.00
†
firm to process 25 shipping orders per week. $300 – $150 – $30 = $120 cost of unused capacity
§
$300 is the weekly cost of Activity A
Thus, the number of sales orders is the cost

Activity-based Costing for the Small Business: A Primer 65

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 t
ABC was used in determining manufacturing

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Table 8 costs per unit, we must now relate the numbers
Marketing and Distribution Costs Using ABC of sales and shipping orders to each product. If
(100 Units of Product P and 30 Units of Product Q) we assume that Product P will be ordered and
shipped in larger quantities than will Product Q,
Unused we might conclude that the sale of 100 units of
Product Product Capacity Total Product P would require 10 sales orders and 15
P Q Costs Costs
shipping orders. Such a conclusion would result
Marketing Activity $1,000* $900 $100† $2,000§
in a factor of .10 (10 sales orders ÷ 100 units of

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Distribution Activity 600 360 40 1,000
Total $1,600 $1,260 $140 $3,000 Product P) to relate sales orders to units of Prod-
uct P. Similarly, a factor of .15 (15 shipping or-
Product Product ders ÷ 100 units of Product P) would relate ship-
Cost Per Unit P Q ping orders to units of Product P. The factors for
Marketing Activity $10.00 $30.00 relating marketing and shipping activities to Prod-
Distribution Activity 6.00 12.00 uct Q would be estimated using the same method.
Total Per Unit $16.00 $42.00 In this example, we assume that the factor relat-
ing the marketing and distribution activities to
* 100 units of Product P x factor of .10 x $100 charging rate = $1,000

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† Product Q is .3 in both cases.
$2,000 – $1,000 – $900 = $100 cost of unused capacity
§
$2,000 is the weekly cost of the marketing activity Table 8 shows the calculation of these costs
assuming the sale of 100 units of Product P ($16)
Charging Rate Calculations: and 30 units of Product Q ($42). Product P is sold
Marketing Activity = $2,000 ÷ 20 sales orders = $100 per sales order and shipped in larger quantities than Product Q,
Distribution Activity = $1,000 ÷ 25 shipping orders = $40 per shipping order so each sales order for Product P is for larger
quantities than each order for Product Q. The
same is true for shipping orders. If the marketing
Table 9 effort is nearly the same for each sales order and
Weekly Income Statement Using ABC
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the distribution effort is nearly the same for each
(100 Units of Product P and 30 Units of Product Q Per Week)
shipping order, then the marketing and distribu-
Unused
tion cost per unit should be lower for Product P
Product Product Capacity than for Product Q. These results are very differ-
P Q Cost Total ent from the costs that would have been allocated
Sales $11,500.00 $3,600.00 --- $15,100.00 to each product based simply on units sold or
Raw Material 4,500.00 1,200.00 --- 5,700.00 sales dollars. ABC results in a more accurate un-
Throughput $7,000.00 $2,400.00 --- $9,400.00 derstanding of the marketing and distribution
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Activity A $187.50 $37.50 $75.00 $300.00 costs associated with each product.
Activity B 3,000.00 1,800.00 0 4,800.00 Table 8 also shows that there are still some
Activity C 250.00 25.00 125.00 400.00 unused capacity costs associated with both the
Activity D 312.50 31.25 156.25 500.00 marketing and distribution activities. If either of
Marketing Activity 1,000.00 900.00 100.00 2,000.00
Distribution Activity 600.00 360.00 40.00 1,000.00
these activities had been a constraint at this level
Total Fixed Costs $5,350.00 $3,153.75 $496.25 $9,000.00 of sales, there would have been no unused ca-
Pre-Tax Profit $1,650.00 ($753.75) ($496.25) $400.00 pacity costs associated with it.
It is important to note here that if sales per-
Product Product sonnel were compensated using commissions
No

Per Unit Amounts P Q based on unit sales or product revenues, the

Sales $115.000 $120.000 commission costs would be capable of being
Raw Materials 45.000 40.000 related directly to each product. In such a situa-
Throughput $70.000 $80.000 tion, the commission costs would be isolated
Activity A $1.875 $1.250 from the marketing costs and attributed to prod-
Activity B 30.000 60.000
Activity C 2.500 .833
ucts, just as raw material costs were. Similarly, if
Activity D 3.125 1.042 advertising costs were capable of being identified
Marketing Activity 10.000 30.000 with specific products, they would not be at-
Distribution Activity 6.000 12.000 tached to products based on the sales order cost
Total Fixed Costs $53.500 $105.125 driver. Instead, the product-related advertising
Pre-Tax Profit $16.500 ($25.125) costs would be separated from the marketing
Do

costs and shown as direct costs for the product

Throughput—a term coined by Goldratt (1990) and used in conjunction with to which they are related. After the separation of
his Theory of Constraints—which is sales less raw material costs, is the same the commission and direct advertising costs from
as contribution margin (an accounting term) in a situation in which raw mate- those of the marketing activity, the remaining
rial costs are the only true variable costs (costs that vary in direct proportion
to the number of product units).
marketing activity costs would be attached to
each product based on its sales orders.

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 t
Strategic Considerations Using ABC preneur or small busi-

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ness owner could use Table 10
A pro forma weekly income statement may be this information to Weekly Income Statement (Per Unit)
prepared if we assume the selling price of each pursue the longer-term Using Absorption Costing: 100 Units
product. If Product P sells at $120 per unit and goal of making Prod- of P and 30 Units of Q Per Week
Product Q at $115, the income statement for one uct Q profitable. The
week is as shown in Table 9 when 100 units of ABC information in Product Product
Product P and 30 units of Product Q are made and Table 9 shows that an Per Unit Amounts P Q
Sales $115.00 $120.00

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sold. Product P has a per unit profit of $16.50, attempt to improve the
Raw Materials 45.00 40.00
but Product Q has a per unit loss of $25.125. The process by which Ma- Throughput $70.00 $80.00
company’s weekly pretax profit is $400 and there chine B works on Machine A $12.00* $8.00*
is unused capacity cost of $496.25. Again, Activity Product Q may have Machine B 12.00* 24.00*
B is the constraining activity as shown by its lack the greatest potential Machine C 12.00* 4.00*
of any unused capacity. for cost reduction. Machine D 12.00* 4.00*
If we had used absorption costing and allo- That cost ($60 per Marketing/Distribution 22.85† 23.84†
cated the marketing and distribution costs on the unit) accounts for Total Fixed Costs $70.85 $63.84
basis of sales dollars, the total company weekly slightly less than 60 Pre-Tax Profit ($.85) $16.16

yo
pretax profit would have been the same $400.
However, there would have been no explicit in-
formation about the cost of unused capacities in
each activity, and the profitability of each product
would have been distorted by the allocation of
the unused capacity costs to the products. Table
10 shows that Product P would have had a loss
of 85¢ per unit and Product Q would have had a
profit of $16.16 per unit.
op
Thus, absorption costing reveals a very differ-
ent product profitability situation from the one
revealed by ABC. One might question which basis
for determining that profitability is more accurate.
An analysis of the underlying reasons for cost
incurrence offers some insight. Product Q makes
extensive use of an expensive resource (Machine
B) and marketing and distribution are heavily
tC
percent of the total
fixed costs devoted to *Per Table 2
†
making and selling the Allocation of $3,000 of marketing and distribu-
product. As discussed tion costs based on dollar sales of each product
earlier, any improve- in relation to total sales dollars.
ment in the process for
Machine B will create additional unused capacity
that can then be sold. The extent to which unit
sales could be increased would, of course, be
limited by still another activity that would be
revealed to have no unused capacity at the
higher level of unit sales. At least the entrepre-
neur or owner would be aware of the activity
that should receive attention during continuous
focused process improvement.
Table 9 also reveals that Product Q has mar-
keting costs, on a per unit basis, that are three

devoted to Product Q despite its low quantity of
weekly sales. ABC recognizes these excessive
demands by allocating the activity costs to prod-
ucts based on the cost driver for each activity.
The use of a cost driver that is uniquely related
to each activity permits a more precise measure
of the extent to which each product or service
places demands on each activity. Such additional
precision renders the ABC approach more accu-
No
times those for Product P. This difference is ex-
plained by the fact that Product Q is sold in small
quantities—information that can be used to evalu-
ate various cost-effective means of raising its
order size. Still another possibility is that Product
Q is not properly priced. Clearly, its price is not
currently high enough to cover the costs of all
the resources used in producing and selling it.
Thus, ABC provides information that will invite a

rate than absorption costing. reevaluation of product pricing.

The choice of product costing approach has
tremendous implications for those seeking to
develop a marketing strategy. Absorption costing
reveals that Product P is being produced and sold
at a loss and Product Q at a profit. If this were
the only information being provided by the ac-
counting system in support of planning and deci-
sion making, one would be inclined to develop a
strategy of promoting Product Q in an attempt to
sell more of it.
Do
Some entrepreneurs or small business own-
ers, upon seeing the ABC information, might be
inclined to eliminate a product that could not be
priced to yield a profit. However, until a more
profitable product can be found to replace Prod-
uct Q, it should be retained. Eliminating it would
cause all the associated fixed costs to move to
unused capacity costs, and all the throughput
(sales minus raw materials cost) associated with it
would be lost. In other words, there would be a

On the other hand, the more accurate ABC
information reveals that Product P is the profit-
able product and Product Q is a loss-maker. This
information also has the advantage of identifying
the elements of cost that render Product Q un-
profitable. From a strategic perspective, the entre-
reduction in throughput with no reduction in
fixed costs. The company’s pre-tax profit would
decline by the throughput contributed by Product
Q—the weekly $400 pretax profit would become
a weekly loss of $2,000 (a $2,400 change based
on 30 units at throughput of $80 per unit).

Activity-based Costing for the Small Business: A Primer 67

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ABC in Service
os
Table 11 Firms
Possible Activities and Related Cost
Drivers for Home Infusion Business In the manufacturing
example used to de-
Activity Cost Driver scribe ABC, the pro-
Supply Acquisition Number of Supply Orders duction activities were
Compounding Number of Labor Hours called Activities A, B,
Home Delivery Number of Prescriptions
rP
Billing Number of Insurance Claims
C, and D and the
products were P and
Q. If the example had
been, say, a home infusion therapy firm, those
four activities would have been supply acquisi-
tion, compounding, home delivery, and billing,
and the services provided would have been infec-
tious disease care, oncology services, and nutri-
tion supplements. Essentially a distribution busi-
yo
ness with a value-added service, a home infusion
firm provides compounded pharmaceuticals to
patients in their homes in lieu of a hospital stay.
Its activities and related cost drivers would have
been as shown in Table 11.
An ABC approach might reveal that provid-
ing nutrition supplements to patients in the home
is the most profitable of the products and that
providing oncology services is not profitable at
op
all. Such a revelation should encourage manage-
ment to examine the process by which oncology
services are provided in order to lower the costs.
Moreover, the firm may be encouraged to recon-
sider the price charged for oncology services.
A bsorption costing must be used as the
basis for valuing inventory and deter-
tC
mining profits when the financial state-
ments are provided to investors, lenders, and IRS
authorities. However, product income statements
used by management for short-term tactical and
long-term strategic decision making are not sub-
ject to the same restrictions. As entrepreneurs or
small business owners seek information on which
to base management plans and decisions, it is
important to realize that there is an alternative to
No
simply using the same information provided to
the outside agencies.
Activity-based costing is an accounting sys-
tem that uses the accounting database required
for external financial reporting to prepare prod-
uct profitability and unused capacity cost infor-
mation in support of managerial planning and
decision making. Whereas absorption costing
focuses only on manufacturing costs, ABC ex-
pands the focus to all the costs of manufacturing,
marketing, and distributing the products. This
Do
expansion is particularly important for mass-
market consumer products, for which marketing
68
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Permissions@hbsp.harvard.edu or 617.783.7860
t
and distribution may cost significantly more than
manufacturing. Further, ABC attributes the mar-
keting and distribution costs to products based
on the extent to which each places demands on
those activities.
ABC provides management with information
on unused capacity costs to assist it in making
tactical decisions about product mix, given the
situation to be faced in the short term. This un-
used capacity cost for each activity also provides
the entrepreneur or small business owner with
the information needed to increase production by
making focused process improvements in activi-
ties that are revealed to have no unused capacity.
Better information for strategic planning and
decision making is also a major benefit. The ABC
product profitability income statement reveals the
extent to which each product is profitable. The
entrepreneur or small business owner can act
strategically on this by developing appropriate
marketing strategies, conducting focused continu-
ous process improvements for product profitabil-
ity, reevaluating product pricing, or considering
the replacement of some products with others
that are more profitable.
ABC is not a separate accounting system. It
merely draws data from the same accounting
database used to prepare the financial statements
for external users. And the fact that modern ac-
counting systems are typically computerized
means that ABC systems can be implemented
rather easily. ❒
References
E.M. Goldratt, The Haystack Syndrome: Sifting Informa-
tion Out of the Data Ocean (Croton-on-Hudson, NY:
North River Press, 1990): 10-22, 64-71.
M. Gupta, S. Baxendale, and K. McNamara, “Integrat-
ing TOC and ABCM in a Health Care Company,” Jour-
nal of Cost Management, July-August 1997, pp. 23-33.
R.S. Kaplan and R. Cooper, Cost and Effect: Using
Integrated Cost Systems to Drive Profitability and Per-
formance (Boston: Harvard Business School Press,
1998): 126-135.
P.B.B. Turney, Common Cents: The ABC Performance
Breakthrough (Hillsboro, OR: Cost Technology, 1991):
39-40.
Sidney J. Baxendale is a professor of
accountancy at the University of Louis-
ville, Kentucky.
Business Horizons / January-February 2001