Activity-based costing (ABC) is a managerial accounting technique that allocates costs to
specific organizational activities rather than mixing them. By identifying the activities that
consume resources, ABC gives managers a more precise understanding of where expenditures
originate and how they relate to strategic decisions. This strategy analyzes variable costs and
fixed expenses, which may fluctuate with variations in activity levels.
Activity-based costing (ABC) determines the expenses incurred by cost items such as products
and customers by estimating the resources used. This technique assumes that cost objects initiate
operations that subsequently consume valuable resources. Activities fill the gap between costs
and cost items. ABC focuses on overhead expenses, including production and
sales/administrative overhead. The consideration of direct labor and materials is usually
consistent between traditional and ABC costing approaches.
Activity-based costing uses a formula that divides the overall cost of a cost pool by the cost
driver. This computation produces the cost driver rate, essential when calculating the overhead
and indirect costs associated with specific operations. The cost driver rate is a crucial indicator in
activity-based costing techniques, allowing businesses to allocate expenses to specific activities
based on resource utilization.
ABC Concepts Application in Setting Prices
Incorporating Activity-Based Costing (ABC) into pricing strategies empowers businesses to craft
pricing models that accurately reflect the costs associated with servicing both low
volume/revenue and high volume/revenue customer segments. ABC offers a detailed breakdown
of the costs for each activity in the production and delivery chain, thereby identifying the specific
cost drivers.
Low Volume / Revenue Customers
For customers with smaller order sizes or lower revenue transactions, ABC highlights the
significant impact of fixed costs on a per-unit basis. Since activities are spread over fewer units,
the cost per item increases. This necessitates a pricing strategy that accounts for these higher per-
unit costs to ensure profitability. Businesses may need to charge a premium on these smaller
orders to cover the intensive resource utilization and bespoke services often required by such
customers.
High Volume / Revenue Customers
In contrast, high volume/revenue customers benefit from economies of scale, where the fixed
costs are spread over a larger number of units, significantly reducing the cost per unit. This
allows for a competitive pricing strategy that can offer lower per-unit prices to these customers,
building long-term relationships and encouraging larger orders. The efficiency gains in
production and logistics for high volume orders enable businesses to maintain profitability even
at reduced per-unit prices.
Applying ABC allows businesses to tailor pricing strategies according to the actual activities and
resources involved in fulfilling the needs of different customer segments. This approach ensures
that pricing is not only based on the genuine costs of production and delivery but also flexible
enough to cater to the distinct requirements and value propositions of various customer groups,
thereby promoting sustainability and profitability.
