MBA Activity-Based Costing Concept Card Template (ABC, TDABC)

Activity-Based Costing Concept Card: [Product, service or course]

A concept card for activity-based costing (ABC) and its simpler successor, time-driven ABC (TDABC), as taught in the managerial accounting core of a leading MBA programme: why volume-based overhead allocation distorts product and customer costs, how to build a two-stage ABC model with the cost hierarchy, how TDABC uses capacity cost rates and time equations, and how managers act on the results (pricing, product mix, cost-to-serve and process redesign). It is for MBA students preparing for class, cases and exams, and for managers in manufacturing, retail, logistics and services who suspect their cost system hides losses. Source basis: Cooper and Kaplan (1988), Cooper (1990) on the cost hierarchy, Kaplan and Anderson (2004) on time-driven ABC, and the standard textbooks named in the reading list, written up in original words. The companies and numbers are fictional and were computed in Python. Replace every [bracketed] value and every row marked Example.

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Contents

• When to use it
• The idea in plain language
• Formulas and notation
• Assumptions and limits
• How managers use it
• Worked example A (fully solved)
• Worked example B (half solved)
• Exercise C (unsolved)
• Connections to other cards
• Common mistakes and misconceptions
• Self-test questions
• My notes and next steps
• Sources and further reading
• Answer key

When to use it

One-sentence rule: use ABC when indirect costs are a large share of total cost and products, services or customers consume overhead resources in proportions that differ from their volume.

Use time-driven ABC when the activity list would be long, processes change often, or interviews about how staff split their time are unreliable. Kaplan and Anderson (2004) proposed it precisely because classic ABC models were expensive to build and maintain and tended to hide unused capacity.

The idea in plain language

A traditional cost system adds overhead to products with one volume-based rate, such as overhead per direct labour hour or per machine hour. That works if overhead is driven by volume. Much of it is not. A machine set-up costs the same whether the batch has 50 or 5,000 units; designing a new tent costs the same whether the company sells 2,000 or 20,000 of it; handling a purchase order costs the same whether it is for one bolt of fabric or one hundred. When such costs are spread by labour hours, high-volume standard products absorb most of them, and low-volume, complex products look cheap. Cooper and Kaplan (1988) showed how this distortion leads companies to price standard products too high, to lose them to focused competitors, and to keep adding complex variants that look profitable but are not.

ABC fixes this in two stages. Stage 1 traces resource costs (salaries, equipment, space) to the activities that use them: set-ups, purchasing, engineering, machine operation, customer service. Stage 2 assigns each activity's cost to products, services or customers in proportion to their use of a cost driver: the number of set-ups, purchase orders, engineering hours, machine hours, orders or deliveries.

Cooper (1990) organised activities into a cost hierarchy:

Facility-sustaining costs are not caused by any product. Many ABC designs leave them unassigned (reported as a company-level cost) rather than spread them arbitrarily; if a full cost is needed, for example for long-run pricing, assign them with a reasonable basis and say so.

Time-driven ABC skips the step that made classic ABC slow: asking employees what percentage of their time they spend on each activity. It needs only two estimates per resource group: the cost of the capacity supplied and its practical capacity (usually 80% to 85% of theoretical time, after breaks, training and meetings). Their ratio is the capacity cost rate (USD per minute). Then time equations say how many minutes each transaction takes, with extra terms for its features (gift wrap, international shipping, a rush delivery). Multiplying minutes by the rate gives the cost of each order or customer, and the gap between capacity supplied and capacity used shows unused capacity explicitly, which classic ABC, by spreading all cost over actual activity, tends to hide.

The point of ABC is not a more precise number. It is a better management conversation: which products, customers and processes consume resources, which ones earn more than they cost, and where process redesign or a pricing change would help. Kaplan and Cooper call this activity-based management.

Formulas and notation

Traditional plant-wide rate:

ABC activity rate and cost assigned to cost object $j$:

Time-driven ABC:

Assumptions and limits

The most important limit: ABC costs are long-run resource costs. Dropping the expedition tent tomorrow would not release the engineers or set-up crews; it would create unused capacity. The saving appears only when managers remove or redeploy that capacity. That is why ABC tells you where to look, and relevant costing tells you what a specific decision will save.

How managers use it

• Product pricing and mix. Raise prices or set minimum batch sizes on complex, low-volume variants; defend standard products with sharper prices once their true cost is visible.
• Cost-to-serve and customer profitability. Rank customers by profit after the cost of orders, deliveries, rush shipments, returns and sales visits. Plotting cumulative profit against customers ranked from most to least profitable usually gives a "whale curve": a minority of customers earns more than total profit and the tail destroys part of it.
• Menu pricing for services. Charge separately for rush delivery, small orders or returns, so that customers who cause the cost see it.
• Process improvement. Activity rates show where to redesign: a set-up costing USD 3,000 is a reason to invest in quick changeover (mba/mba-process-analysis-card).
• Capacity planning. TDABC shows unused capacity in minutes and dollars, which budgets can then reduce or redeploy.
• Healthcare and service operations. TDABC is widely used to cost care pathways and service processes, where the main resource is staff time.

Worked example A (fully solved): two tents, two cost systems

Situation (fictional). Northfield's tent workshop makes two models. The Standard dome tent sells 20,000 units a year at USD 210. The Expedition tent is a low-volume, complex model: 2,000 units a year at USD 560, many fabric types, frequent design changes and small batches. Workshop overhead is USD 1,500,000 a year. Direct labour costs USD 30 per hour.

Traditional system: one plant-wide rate on direct labour hours. Total DLH = 20,000 x 1.0 + 2,000 x 2.5 = 25,000. Rate = USD 1,500,000 / 25,000 = USD 60 per DLH (=1500000/SUMPRODUCT({20000,2000},{1,2.5})).

ABC system. An activity analysis splits the USD 1.5m into five pools.

Check: 765,000 + 735,000 = 1,500,000, all overhead assigned.

Reading the result. Under the traditional system the expedition tent looked like the better product (USD 145 a unit, a 25.9% margin). ABC shows it loses USD 72.50 a unit, about USD 145,000 a year, because it takes two thirds of the set-ups, most of the purchase orders and three quarters of engineering time while making only 9% of the units. The standard tent was overcosted by USD 21.75 a unit: the traditional system loaded it with USD 1.2m of overhead, against USD 765,000 under ABC. Total profit does not change (USD 1,290,000 under both systems), but the picture of where it comes from does. Leaving facility costs unassigned changes little: the expedition tent's cost would be USD 617.50, still above its price.

What a manager does next. Options include a higher price for the expedition tent, fewer fabric variants and larger batches (fewer set-ups and orders), a quick-changeover project, a design freeze to cut engineering hours, or dropping the model. Before dropping it, run a relevant-cost analysis: the set-up crews and engineers would not disappear on their own, so the saving depends on what capacity is actually removed or redeployed.

The black tick marks the selling price: the expedition tent's ABC cost sits above it.

Worked example B (half solved): time-driven ABC in the fulfilment centre

Situation (fictional). Northfield's e-commerce fulfilment centre has 40 staff. In a quarter of 60 working days of 7.5 hours, theoretical capacity is 40 x 60 x 7.5 x 60 = 1,080,000 minutes. Management estimates practical capacity at 80%, after breaks, training and team meetings. The quarterly cost of the centre (staff, supervision, equipment, space and systems) is USD 777,600.

Time study and system data give this time equation for an order:

and 12 minutes for each processed return. In the quarter, the centre shipped 90,000 orders averaging 2.5 lines; 8,000 had gift wrap, 6,000 were international, and it processed 9,000 returns.

10. The marketing team proposes free gift wrap on every order. What would it cost per order? [ ]
11. What should management do with the unused capacity? Give two options. [ ]

Exercise C (unsolved): cost to serve two wholesale customers

Northfield sells to independent outdoor retailers. An ABC study of the wholesale team gives these activity rates: order processing USD 45 per order, standard delivery USD 120 per delivery, rush delivery USD 300 per rush delivery, sales visit USD 250 per visit, and return handling USD 18 per unit returned.

1. Compute the gross margin in USD for each customer.
2. Compute the cost to serve of each customer by activity, and in total. Give the Excel formula (=SUMPRODUCT).
3. Compute customer profit and profit as a percentage of revenue.
4. Which activities drive Retailer B's cost to serve? Propose three changes to the terms of trade.
5. Why might Northfield keep Retailer B even if it is unprofitable today?

Connections to other cards

Common mistakes and misconceptions

1. Treating ABC cost as avoidable cost. Dropping a product creates unused capacity; it saves money only if capacity is removed or redeployed.
2. Using too many activities. Fifty pools add cost and false precision; most models need 5 to 15 well-chosen activities.
3. Choosing drivers that are easy to count rather than causal. The driver must explain why the activity cost changes.
4. Spreading facility-sustaining costs arbitrarily and then deciding on the result. Leave them unassigned or disclose the basis.
5. Dividing by actual instead of practical capacity. Rates then rise when volume falls and push prices up exactly when demand is weak.
6. Forgetting the reconciliation. Assigned cost plus unused capacity must equal total cost.
7. Relying on time-split interviews. Staff estimates tend to add up to 100% of time and hide idle capacity; TDABC time equations avoid this.
8. Reading ABC as a one-off project. Processes and products change; without an owner and an update routine, the model goes stale.
9. Concluding "drop the unprofitable customers". Often the right action is to change terms (minimum order, delivery fees, return policy) or serve them through a cheaper channel.
10. Ignoring the strategic role of complex products. A loss-making variant may anchor a brand or win a key account; say so and quantify the cost of that choice.

Self-test questions

1. Explain in two sentences why a plant-wide labour-hour rate overcosts high-volume standard products.
2. Name the five levels of the cost hierarchy and give one driver for each.
3. In Worked example A, why does total profit stay at USD 1,290,000 under both systems?
4. What is the main advantage of time-driven ABC over classic ABC? Give two.
5. With a capacity cost rate of USD 0.90 a minute and a time equation of 4 + 0.8 x lines minutes, what does a 10-line order cost?
6. Why should a capacity cost rate use practical rather than theoretical or actual capacity?
7. What is a whale curve, and what does it tell a sales leader?
8. A manager wants to drop the expedition tent because ABC shows a loss of USD 145,000. What do you ask before agreeing?
9. Give one service-sector example where TDABC would be useful and the main resource it would cost.
10. What is activity-based management, and how does it differ from activity-based costing?

My notes and next steps

Sources and further reading

• Cooper, R., and Kaplan, R. S. (1988). Measure costs right: make the right decisions. Harvard Business Review, 66(5).
• Cooper, R. (1990). Cost classification in unit-based and activity-based manufacturing cost systems. Journal of Cost Management, Fall 1990.
• Kaplan, R. S., and Anderson, S. R. (2004). Time-driven activity-based costing. Harvard Business Review, 82(11), 131–138.
• Kaplan, R. S., and Anderson, S. R. (2007). Time-Driven Activity-Based Costing: A Simpler and More Powerful Path to Higher Profits. Harvard Business School Press.
• Johnson, H. T., and Kaplan, R. S. (1987). Relevance Lost: The Rise and Fall of Management Accounting. Harvard Business School Press.
• Textbooks, by name only: Kaplan, R. S., and Cooper, R., Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance (Harvard Business School Press); Datar, S. M., and Rajan, M. V., Horngren's Cost Accounting: A Managerial Emphasis (Pearson); Garrison, R. H., Noreen, E. W., and Brewer, P. C., Managerial Accounting (McGraw Hill).
• Open resource: OpenStax, Principles of Accounting, Volume 2: Managerial Accounting (CC BY-NC-SA 4.0), https://openstax.org/details/books/principles-managerial-accounting, chapter on activity-based, variable and absorption costing.

Answer key

Worked example B. (2) USD 0.90 per minute. (4) =8000*3, =6000*6, =9000*12. (5) 540,000 + 24,000 + 36,000 + 108,000 = 708,000 minutes (USD 637,200 assigned, =708000*0.9). (6) 864,000 - 708,000 = 156,000 minutes, 18.1% of practical capacity, costing USD 140,400 (=(864000-708000)*0.9). (7) 9.4 minutes, USD 8.46. (8) =(4+0.8*5+6)*0.9 = 14 minutes, USD 12.60. (9) =12*0.9 = USD 10.80. (10) USD 2.70 of handling per order (3 minutes at USD 0.90), plus materials. Applied to the 82,000 orders that do not have it today, it would add 246,000 minutes (=82000*3), more than the 156,000 minutes of unused capacity, so it would need extra staff. (11) Reduce capacity (fewer temporary staff, fewer shifts) or redeploy it (wholesale picking, returns refurbishment, a same-day service), and report the unused cost in the budget rather than loading it onto orders.

Exercise C.

(4) Small, frequent orders and deliveries (USD 89,400), returns (USD 43,200) and rush deliveries (USD 27,000). Changes: a minimum order value or a delivery fee below it, a rush-delivery surcharge, a returns allowance with a restocking fee, and sales visits replaced by a monthly video call. (5) Strategic reasons: it may be a growing chain, a showcase location, or a source of market information; the shared costs of delivery routes may not fall if it leaves; and changing terms may turn it profitable at lower risk than ending the relationship.

Self-test.

1. Labour hours rise with volume, so high-volume products absorb most overhead, including batch and product-sustaining costs that are really caused by low-volume, complex products. The complex products are undercosted and the standard ones overcosted.
2. Unit (machine hours), batch (set-ups or purchase orders), product-sustaining (engineering hours), customer-sustaining (sales visits or accounts), facility-sustaining (usually not assigned, or floor area).
3. Both systems assign the same USD 1.5m of overhead; they only move it between products. Total revenue and total direct costs are unchanged.
4. It is cheaper to build and update (two estimates per resource group plus time equations), it handles variety through features in the equation, and it shows unused capacity explicitly.
5. (4 + 8) x 0.90 = USD 10.80.
6. Practical capacity keeps the rate stable when volume changes and puts the cost of idle capacity in a visible line instead of loading it onto products; theoretical capacity ignores unavoidable breaks and understates the rate.
7. A plot of cumulative profit against customers ranked from most to least profitable. It rises above 100% of total profit and then falls, showing that a group of customers destroys part of the profit others create.
8. Which costs would actually be removed (relevant costing), whether the model supports sales of other products or a key account, whether price, batch size or variant count can be changed first, and how the facility costs were assigned.
9. A hospital outpatient pathway, costing nurse, physician and room minutes; a bank's account opening, costing staff and back-office minutes.
10. Activity-based management uses ABC information to act: redesign processes, change prices and terms of trade, rationalise products and customers, and manage capacity. ABC is the measurement; ABM is the management.

Revision history

Standard and licence note

Based on the activity-based costing literature listed above (Cooper and Kaplan 1988; Cooper 1990; Kaplan and Anderson 2004 and 2007) and the standard cost accounting textbooks named as further reading. The text, the worked examples, the exercises and the questions are original; no textbook or article text is copied or paraphrased, and Northfield Outdoor Co. is a fictional company. This card is independent and not affiliated with or endorsed by any business school, publisher, consultancy or professional body. Check your course's notation and current practice before you rely on it. Template licence: MIT.