Activity-based costing (ABC)
Activity-based costing assigns overhead and indirect costs to products or services based on the actual activities that drive those costs, rather than using broad allocation methods. ABC provides more accurate cost visibility for procurement and sourcing decisions.
Examples
Supplier total cost comparison: A buyer evaluates two component suppliers. While Supplier A has a lower unit price, ABC reveals that their smaller lot sizes drive higher receiving, inspection, and storage activities. When activity costs are allocated, Supplier B's total cost of ownership is lower.
Make-vs-buy analysis: Using ABC, a procurement team calculates the true internal cost of manufacturing a subassembly by tracing all activities: setup, machine time, quality checks, material handling, and engineering support. This accurate baseline enables meaningful comparison against supplier quotes.
Cost reduction targeting: ABC analysis reveals that incoming inspection activities consume 12% of a component's landed cost. This insight drives a project to qualify suppliers for skip-lot inspection, directly reducing a measurable cost driver.
Definition
Traditional costing methods allocate overhead using simple volume-based measures like direct labor hours or machine hours. This works when overhead is small relative to direct costs, but distorts product costs when indirect activities vary significantly across products or suppliers.
ABC improves accuracy by identifying the specific activities that consume resources—receiving shipments, processing orders, conducting inspections, managing inventory—and assigning costs based on each product's actual consumption of those activities.
For procurement, ABC supports better sourcing decisions by revealing hidden costs that simple price comparisons miss. A supplier with a higher unit price but fewer quality issues, simpler logistics, and less administrative overhead may actually cost less when all activities are considered.
Implementing ABC requires effort to map activities and collect consumption data, so organizations typically apply it selectively to high-value categories where cost distortion is likely and better information would change decisions.
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