How activity-based costing can improve business performance

Your income statement indicates whether your business is profitable — but it doesn’t always explain why. For many small businesses, traditional cost accounting can mask where time and money are really being spent. Activity-based costing offers a practical way to understand the true cost of the work you perform, helping you make better decisions about pricing, profitability and operational efficiency.

How does activity-based costing work?

With activity-based costing, you assign costs to specific activities based on the resources they consume. Think of activities as the building blocks of your operations — such as setting up equipment, processing invoices, completing service calls or performing quality checks. Implementing activity-based costing generally involves four steps:

1. Identify activities. Create a list of tasks your company performs to deliver a product or service. Define each activity in such a way that there’s no overlap and everyone understands what’s included.
2. Allocate resources. For each activity, identify the resources used, such as materials, equipment time, labor hours and subcontracted services.
3. Calculate the per-unit cost of each resource. Choose a standard, measurable unit for each resource and calculate the cost per unit. For example, if a box of 100 screw anchors costs $30, the per-unit cost is 30 cents per anchor. For labor, the unit is typically an hourly wage or fully burdened labor rate.
4. Determine resource consumption and allocate indirect costs. Estimate how many units of each resource each activity consumes, then multiply by the per-unit cost. Indirect costs — such as rent, equipment leases, administrative salaries and software subscriptions — are allocated using reasonable cost drivers, such as square footage, machine hours or transaction volume, to arrive at the total cost of each activity.

What insights can activity-based costing provide?

Activity-based costing can provide meaningful insights into what’s working — and what’s not. For example, if a job or service line is consistently less profitable than expected, whether from excessive labor time, inefficient processes or underutilized equipment, it can help pinpoint where costs are accumulating. This approach can help management identify inefficiencies early and take corrective action before margins erode.

You may also uncover spending patterns that lead to better purchasing decisions and improved cost control. From a strategic standpoint, activity-based costing provides a clearer picture of which products, services and customers contribute most to profitability — and which may need to be repriced, redesigned or discontinued.

Estimating and pricing can also improve with activity-based costing. By breaking work into well-defined activities, businesses can build more accurate estimates and adjust them more easily when scope changes. Activities essentially become flexible line items that can be added, removed or refined as projects evolve.

Is it right for your business?

Activity-based costing is designed to supplement, not replace, your traditional accounting system. It works best for businesses with multiple offerings, significant overhead or processes with varying complexity. While the methodology can seem intimidating at first, modern accounting and project management software can significantly reduce your data burden. Contact us to discuss whether activity-based costing is a good fit for your business and how it can be implemented in a practical, scalable way based on your operations, goals and resources.

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