In traditional cost accounting, all manufacturing costs are assigned to products, while non-manufacturing costs (general administrative costs, sales and marketing costs, etc.) are grouped into overhead, which are then allocated out to products based on either labor hours or machine hours. While this system is simple, it has inherent flaws, most significant of which include the inability to determine the true cost of producing and supporting a product. This inability, in turn, can lead to poor strategic decisions, as some products that appear profitable by traditional cost accounting measures, in fact, are not profitable (and vice versa).
To overcome these flaws, many companies are moving to activity-based costing (ABC). In ABC, the goal is to considerably reduce the overhead pool by assigning as many costs as possible directly to the products consuming the resources, and to allocate the remaining costs to predetermined activities pools. Activities can be broken down into unit-level, batch-level, product-level, customer-level and organization-level.
Notable piano manufacturer, Steinway & Sons, is an excellent example of a company that could benefit considerably from implementing activity based costing (ABC). For example, Steinway pays considerable money in shipping charges. Its pianos are meticulously crafted by numerous raw materials, all of which must be shipped to the assembly floor. In traditional cost accounting, shipping charges are reflected in overhead (as a general administrative expense) and allocated out to product units. At Steinway, however, each piano line is constructed differently, from different raw materials. A concert grand piano, for example, uses 18 hard-rock maple layers, each 22 feet long. Smaller pianos do not require as much wood, but time to assemble each style piano can be similar, and requires similarly skilled workforces. If Steinway allocates shipping charges to product units based on labor hours o...