Activity-based costing, or ABC, takes into account all the costs associated with making a product, at the unit level, the batch level, the product level, and the global level.
So how do you actually use your ABC? Here are some basics on how to calculate unit cost using the ABC approach:
- Materials costs: You’re probably getting this right already. But don’t forget to figure in acquisition and handling costs.
- Unit cost: For this you must get an accurate measurement of touch labor and machine hours. The best systems are barcode based, where workers scan a unit at the beginning and end of a task. If this is too costly, you have to time actual operations, and not just once. Time numerous units to get an accurate average.
- Batch cost: This is important. If setup costs $400 and you manufacture 5,000 units, setup adds 8 cents per part, which could be the difference between profit and loss. Depending on the nature of your product line, you may want to include engineering in this number as well.
- Product cost: For a standard product, this means all the development hours.
- Global costs: These are conventional indirect costs such as utilities, management salaries, and so on. They may need to be redefined in the ABC approach. For example, if you include engineering costs at the batch or product level, you should not include them in the indirect cost figure.
When you do a pricing exercise, either for a bid or for a product line, you simply add up all these costs and divide by the number of units.
Warning: ABC is a controversial topic among accountants, and switching to ABC can be complex if you buy into every detail of the theory, start using the new terminology, and so on. I’m not suggesting anything that radical. I’m merely suggesting that if you take a closer look at what it really costs to make what you sell, you’ll almost certainly increase profitability.
I recently chatted with a friend, Charlie Alter, a Toledo-based management consultant to small manufacturing companies for more than 20 years. I specifically asked the question: How hard is it to use the ABC method? His response was, “The hardest thing is to get the accountants out of their chairs and onto the factory floor.” While he was joking, there is truth in what he said. At its core, the ABC approach to costing is nothing more than aligning your pricing process to reality.