Activity-based costing, or ABC, involves breaking down production processes or other areas of a business into activities. These activities are then assigned the expenses they incur. This approach allows firms to identify their resource use in a manner that reveals actual costs and inefficiencies as opposed to employing traditional cost accounting methods, which allocate a share of aggregate measures of overhead to individual product units.
As an example, the operation of a factory can be analyzed by separating it into individual activities, such as the maintenance and management of the physical facility. The individual costs associated with this activity, paying heat and light bills, for example, can then be identified. This gives firms the means to quantify costs at their source and to couple them directly to their pricing. Activity-based costing is beneficial as it separates fixed costs such as utility payments, which cannot be reduced to a significant degree, from variable ones.
Firms adopting ABC have discovered that some of their products were overpriced, while others were not earning sufficient revenue to cover the cost of their production. Similarly, introducing ABC has led to firms devoting separate factories to the production of small orders because it allowed them to tailor physical layouts and other factors to this form of demand, increasing profits.
Activities and their accompanying resource use can also be identified in many other areas of a firm's business. This includes administrative functions, such as human resource management.