Activity Based Costing (ABC) is simply moving as many of your indirect costs into direct costs, or putting it another way, allocating costs above the line into Cost of Goods Sold (Product or Service) rather than below the line into Overhead Expenses.  This gives you the ability to measure more accurately the profitability of specific products and services. 

Indirect costs are often allocated in proportion to the direct costs used to manufacture the product or perform the service, rather than allocating them directly to the activities that actually consumed them.

We assign all the resource costs to the actual product or service which consumed them during the various stages from pre-sale and design; to manufacturing, installation or service stages. These include both direct costs (labour and materials) and indirect costs such as company overhead expenses. 

For example, a manufacturer makes to stock or to order a range of standard machines with different features and options eg Form Fill Seal (FFS) Packaging Machines. They also custom design and fabricate FFS machines for specific production processes. The customised FFS machines consume considerably more of the companies indirect costs at the pre-sale stage which takes longer and involves the company engineer’s time (overhead); design stage requires in-depth thought and dealing with lots of other 3rd parties, regulations and constraints; quoting takes longer because it is new and different; prototyping and testing is added into the process to prove this new concept machine will do the job it is designed for; manufacturing may involve new or extra processes and outwork; QA may need new procedures or testing methodologies; storage could be awkward; transportation runs according to plan; special installation requirements; additional post sale support and servicing is also needed, not to mention all the staff involved from all levels of the organisation in managing the client relationship throughout the entire ‘one off’ project.

Therefore the indirect overhead costs allocated to the stock standard FFS machines should be considerably less than those allocated to the customised FFS machines. This will significantly impact a job’s profitability and will assist you to choose more profitable work and improve the overall productivity of the business.