As originally introduced in the 1980s, ABC corrected serious deficiencies in traditional costing systems. The traditional systems typically used only three cost categories: labor, materials, and overhead. While manufacturing companies could generally trace the labor and materials to their individual products, their cost systems allocated the indirect and support costs- the “overhead”-with measures already being recorded, such as direct labor hours and direct labor dollars.
As the direct labor content of products decreased, through automation and industrial engineering-driven efficiencies, the percentage of overhead costs had continually increased during the twentieth century. In addition, many companies had shifted from mass production strategies to those that offered customers more variety, features, and options. The customer-focused strategy attempted to attract, retain, and grow business by offering services such as the following:
* Producing and stocking a greater variety of products
* Supporting more order-entry and order-tracking channels
* Producing and delivering in smaller order size
* Delivering directly to customers’ end-use locations, often in expedited and narrow time windows
* Providing specialized technical applications support
All these services created value and loyalty among customers, but none came for free. To offer the expanded variety and the new options, features and services, companies had to add (overhead) resources for engineering, scheduling, receiving, storage, inspection, setup, materials handling, packaging, distributing, order handling, marketing, and selling. Overhead costs increased both relatively and absolutely as companies diversified into more products lines, customers, channels, and regions and offered specialized features and services.
By the 1980s, the standard cost systems designed during the scientific management movement seventy-five years earlier no longer reflected the current economic reality. Companies were now operating with distorted information about the profitability of their orders, products, and customers. For example, while traditional cost systems might show that all customers are profitable, the economic reality was that a minority of customers earned between 150 and 300 percent of profits and unprofitable customer relationships lost 50 to 200 percent of profits.
Activity-based costing seemingly solved the inaccurate allocation of overhead from standard cost systems by tracing these indirect and support costs first to the activities performed by the organizations’ shared resources, and then assigning the activity costs down to orders, products, and customers on the basis of the quantity of each organizational activity consumed.
Managers used the more accurate ABC and profitability information to make better decisions about process improvements, order acceptance and rejection, pricing and customer relationships. The decisions led to near-term and sustainable improvements in product and customer profitability.