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Performance Management Best Practice

Profitability Analysis Using Activity-Based Costing

by Priscilla Wisner

ABC: How It Works

Consider an organization with two primary products:

  • The first product is well established in the marketplace, sells in high volumes, and is made from a relatively small number of components. In sum, it is a relatively simple product to make and support. Each month, 2,500 direct labor hours are used to produce 100,000 units of this product.

  • The second product is newer and sells in smaller volumes. It requires a complex series of steps to produce, with modifications to units requested by various customers. Each month, 2,500 direct labor hours are used to produce 25,000 units of this product.

Using a traditional cost allocation methodology, all overhead costs would be assigned using the number of direct labor hours used to produce each product; therefore, each product line would be assigned 50% of the overhead costs because each product line uses 2,500 direct labor hours. However, the second product is more complex to make, in that:

  • more supervisory oversight is needed to ensure that the product is correctly made;

  • each item has to be inspected to make sure that the modifications have been correctly done;

  • the shipped batches are much smaller in size.

Each of these resources—supervision, inspection, packing, and shipping—costs money, and the need for them is increased by the second product line. An ABC allocation would more accurately associate their costs with the product lines that consumed them, thereby assigning more supervision, inspection, and pack-and-ship costs to the second product line. The data in the following example compare a traditional costing outcome with an ABC outcome for the two products.

Case Study

ABC Used to Improve Processes and Evaluate Customer Profitability

Kanthal1 is a global producer of electrical heating material and elements that are used in industries including electronics, chemical, ceramics, medical, and appliances. Headquartered in Sweden, Kanthal sells its products throughout the world. In the mid-1980s, Kanthal implemented an ABC project to help it realize its strategy for higher growth and profitability. The specific goals of the company were to:

  • achieve profit objectives by division, product line, and market;

  • determine order and sales support costs, so that the sales force could make better decisions about customer requests;

  • increase sales without increasing overhead costs.

At the time of the initial analysis, Kanthal had about 10,000 customers and produced about 15,000 items.

The ABC analysis showed that, of Kanthal’s total Swedish customer base, 30% contributed the majority of the profits, about 40% were break even, and 30% were not profitable. The analysis also showed that two of the largest customers were among the least profitable for the firm.

An activity analysis helped to focus on the root causes of the low-margin customers. These were the customers that ordered in small order sizes or in unpredictable amounts, changed their orders frequently, ordered nonstocked or customized products, required additional technical advice and support either pre- or post-sale, demanded large discounts, or were slow to pay invoices. In a culture that focuses on building sales, many firms say yes to one-off customer requests and demands; however, the additional sales volume then comes at costs that very often are not directly associated with the customer’s order.

Kanthal management used the ABC information to change internal processes and also to change its relationships with customers. The firm reduced the variation in product offerings, and used distributors to stock smaller-volume items, enabling it to meet more orders from stock rather than building to order. On-line order entry systems were installed for the large customers. Some customers were given a small discount as an incentive to increase order sizes; for example, when one customer was given a 5% discount to increase order lines by 50%, profitability for that customer increased from 19% to 45%. In one division, average order size increased by over 60%, the percentage of orders fulfilled from stock increased from 36% to 63%, and profitability went from a small loss to a 9% positive margin. For the company as a whole, sales increased by 20% without a corresponding increase in employees, leading to a 45% increase in profitability.

Benefits of ABC

An ABC analysis provides management with a wealth of financial and operational information. The benefits of ABC include the following:

  • Costs are associated with activities that create those costs.

  • Profitability can be calculated from multiple perspectives, such as product line, customer, or market.

  • It provides information about “hidden” losers and winners, i.e. which product lines/customers/markets have lower profit margins than was originally thought and which give better profit margins.

  • It provides cost rates for organizational activities that are helpful for benchmarking and making process decisions.

  • It aligns with business process reengineering work by helping managers to put a price tag on non value-added activities, such as waste or rework.

  • Attention is focused on process costs and how they interact with profitability segments. Armed with explicit measurements of the costs of activities and processes, management can communicate that paying attention to these factors is important. In other words, what gets measured gets managed.

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Further reading


  • Bleeker, Ron R., and Kenneth J. Euske (eds). Activity-based Cost Management Design Framework: Getting It Right the First Time. Austin, TX: Consortium of Advanced Management, International, 2004.
  • Cokins, Gary. Activity-based Cost Management: An Executive’s Guide. New York: Wiley, 2001.
  • Kaplan, Robert S., and Steven R. Anderson. Time-driven Activity-based Costing: A Simpler and More Powerful Path to Higher Profits. Boston, MA: Harvard Business School Press, 2007.


  • The Activity Based Costing Benchmarking Association (ABCBA) is a group of ABC practitioners who share data and best practice information:
  • The Consortium of Advanced Management, International (CAM-I), is an international consortium of business, government, and academic leaders who work collaboratively on cost, process, and performance management issues:
  • The Institute of Management Accountants (IMA) is a global organization that “provides a dynamic forum for management accounting and finance professionals to develop and advance their careers through certification, research and practice development, education, networking, and the advocacy of the highest ethical and professional practices”:
  • The International Federation of Accountants (IFAC) is a global consortium of accountants that promulgates standards and publishes articles and papers on topics of interest in the accounting and finance disciplines:
  • The Management and Accounting Web is dedicated to education, research, and the practice of management and accounting disciplines. Contains links to dozens of management accounting and finance resources:

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