Understanding activity-based costing.
When managing overhead costs, activity-based costing (ABC) clearly shows where money is going and why. Traditional methods can obscure which products drain resources and which drive profit. ABC reveals the hidden costs that traditional accounting masks, helping you determine why a product line might be unprofitable.
This guide explores the definition of activity-based costing, along with the benefits and limitations of the method. You’ll also discover essential implementation steps and learn how Workday helps customers improve their financial decision-making.
Activity-based costing: A smarter way to understand costs.
Activity-based costing helps identify previously overlooked costs that increase overhead. It improves the accuracy of cost attribution and supports informed budgeting and pricing strategies.
With global supply chains spanning continents, cloud infrastructure replacing physical assets, and hybrid labor models transforming workforces, accurately allocating costs has become crucial for today’s businesses. ABC delivers powerful advantages, including better margin visibility and true cost transparency, despite implementation challenges such as extensive data requirements and organizational complexity.
“Firms adopting activity-based costing techniques outperform matched non-ABC firms by approximately 27 percent over the three years starting from implementation.”
—Kennedy and Affleck Graves, Journal of Management Accounting Research
What is activity-based costing?
Activity-based costing (ABC) is a managerial accounting method that assigns overhead and indirect costs to related products and services. It tracks how your company spends money, not just where it goes.
At its core, activity-based costing identifies the true cost drivers in your business—the activities that consume resources—and assigns expenses accordingly. ABC connects activities such as machine setups, quality inspections, or customer support interactions directly to the products, services, and customers they support.
This approach reveals hidden costs that traditional accounting methods miss. For example, a manufacturing company may realize its small-batch products require disproportionate setup time, or a service business may discover certain customers consume a high percentage of support hours while generating a low percentage of revenue. By exposing these realities, ABC empowers leaders to make confident decisions about pricing, product mix, process improvements, and customer relationships.
Why ABC matters in modern finance.
Activity-based costing was introduced in the mid-1980s through work by academics like Robert S. Kaplan. However, the methodology is gaining increased traction today across industries. The rise of service economies, ongoing inflation, and increased supply chain complexity are all driving ABC adoption.
Automation and modern financial systems have removed many implementation barriers. Additionally, digital transformations generate more data, making ABC more feasible.
Companies now leverage ABC for accurate costing and as a strategic lens to evaluate digital investments, optimize hybrid workforces, and identify which customer relationships deserve priority in uncertain economic conditions. The methodology also enables managers to report expenses promptly so leaders can quickly see the total costs of each resource used. The fundamental insight remains: informed decisions result from knowing what drives your costs.
“Before Workday, I couldn’t sit in a strategic meeting and jump into the system and grab an answer. The ability to answer questions on the spot gets us to faster decision-making.”
—VP, Chief Accounting Officer and Controller, Denny’s
Advantages and limitations of activity-based costing.
Activity-based costing offers insights for businesses struggling with complex cost structures, but it comes with trade-offs that are worth considering before implementation.
Advantage: Improved cost transparency.
By tracing expenses to specific activities—such as machine setups, quality inspections, or customer support calls—ABC helps identify hidden inefficiencies that traditional methods often miss. This clarity helps leaders make informed pricing decisions or optimize portfolios based on actual resource consumption rather than arbitrary allocations.
For example, an equipment manufacturer could discover that specialty parts consume disproportionate setup resources, leading to revised pricing that significantly improves margins on these previously underpriced items.
Advantage: More accurate profitability analysis.
ABC reveals which products, services, and customers generate the most profit. This insight informs resource and investment allocation, driving greater overall business profitability.
For example, a financial institution could discover that a small segment of commercial customers generates most of its profits, while another group actually eroded value through high servicing costs, prompting a restructuring of their fee schedules and relationship management approach.
Advantage: Support for lean process improvement.
ABC naturally complements lean initiatives by highlighting activities that don’t add value. This data-driven approach ensures that waste is cut where it matters most—not just where it’s convenient.
For example, an automotive manufacturer could use ABC to identify precisely how much each quality inspection, rework loop, and inventory holding point costs per vehicle, helping them target their improvement efforts.
Limitation: Implementation complexity.
ABC requires significant upfront investment in both time and expertise. Identifying activities, assigning cost drivers, and gathering data can be overwhelming, especially for organizations with complex operations spanning multiple locations or departments. Modern approaches, such as Time-Driven ABC are simpler and faster to implement, overcoming these traditional barriers.
Implementations can also fail because companies underestimate the long-term resources needed to maintain the system, as traditional models require costly re-interviews to update.
Starting with a pilot in one business unit can help demonstrate value before scaling. This allows the team to refine methodologies and build internal expertise before tackling enterprise-wide implementation.
Limitation: Data collection burden.
The accuracy of ABC depends on the quality and quantity of data that supports it. Tracking detailed activity information can be difficult, as staff may resist the additional documentation effort. This leads to incomplete or inaccurate inputs and undermines the system’s credibility.
Industry leaders embed activity tracking into regular operational systems employees already use—production scheduling software, CRM platforms, and project management tools—eliminating duplicate data entry while enhancing reporting accuracy.
Limitation: Scalability challenges.
As companies grow and evolve, ABC models can become overly complex. What starts as a focused costing system often expands into hundreds of activities and drivers, creating a maintenance challenge.
Successful organizations often establish governance frameworks that balance comprehensiveness with practicality. They periodically reassess which activities truly drive significant cost variability and simplify the model to maintain its power as a decision-making tool without introducing unnecessary complexity.
Did you know?
Companies using a tech-enabled cost-reduction approach can cut indirect costs by 15 to 20 percent in 12 to 18 months, according to McKinsey.
Common cost drivers and real-world applications of ABC.
Cost drivers are the measurable factors that trigger resource consumption in your organization. Unlike traditional accounting, which might only count direct labor hours, ABC identifies the key activities consuming your resources. Here are some examples of common cost drivers by industry:
Manufacturing: Machine setups, production runs, and quality inspections
Pharmaceuticals: Batch changes or regulatory compliance activities that drive significant costs despite minimal direct materials
SaaS businesses: Customer onboarding complexity, support tickets, and feature customization requests
Technology companies: Different customer segments served across subscription models
Retailers: Inventory handling frequency, return processing, and omnichannel fulfillment methods
Healthcare providers: Costs beyond physician time, such as equipment sterilization cycles, administrative processing, and regulatory documentation
Activity-based costing vs. traditional costing.
The difference between activity-based costing and traditional costing lies in their methodologies. Traditional costing allocates overhead using broad, volume-based drivers. In comparison, activity-based costing uses specific activities to allocate costs. Businesses gain a more detailed and accurate approach to product and service costs, which enables better decision-making.
Activity-based costing
- More accurate results
- Improved insights allow for better decision-making
- Resources are tracked and costs are assigned to specific activities
Traditional costing
- The process is simplified, meaning results may be less accurate
- A lack of accurate data can lead to less informed decision-making
- Overhead costs are allocated using broad, volume-based averages
Use ABC when your business has diverse products or services with varying production complexities, when overhead costs represent a significant portion of your total expenses, or when you need strategic insights for pricing, process improvement, or customer profitability analysis.
How to implement activity-based costing in your organization.
Implementing activity-based costing in your organization requires a few key steps:
1. Identify key activities and processes.
Identify the activities and processes for which you want to determine the cost. For example, some organizations focus on production costs, while others focus on finding cost-effective third-party partners.
2. Define and select cost drivers.
Choose which drivers influence the activity costs. Is it machine hours or setup times on the production line? The drivers are a vital part of ABC, as they determine activity costs.
3. Assign costs to each activity.
Assign individual activities a specific cost to give an accurate reflection of the total cost.
4. Collect and structure data.
Collecting and structuring the data is a key step for understanding the results. Organize the data by activity, product, or department to make the next step easier.
5. Calculate and analyze results.
Calculate total costs by aggregating expenses tied to specific activities. After using an activity-based costing framework, organizations are better prepared to make decisions.
Components and methods of activity-based costing systems.
Modern activity-based costing systems have four key elements that provide clear visibility into organizational costs.
Activities and cost pools.
Activities are grouped into logical cost pools based on similar functions rather than departments. Organizations should balance detail with simplicity: too few pools may obscure insights, while too many create unnecessary complexity.
Drivers and cost objects.
Effective cost drivers show clear cause-and-effect relationships and are economical to track. Volume-based drivers track simple occurrence counts, while duration drivers measure time spent, offering enhanced accuracy for activities that vary in complexity.
Time-Driven ABC as a variation.
Time-Driven ABC simplifies implementation by using time equations instead of complex activity mappings. This approach calculates capacity cost rates (cost per minute) and estimates the time required for each activity variation. This reduces the implementation burden while accommodating complex business rules.
Reporting and integration.
Today’s ABC systems integrate with ERP and business intelligence platforms, enabling faster cost analysis rather than periodic reviews. This integration produces multidimensional views of profitability and supports predictive modeling of potential business changes. Cloud-based solutions now provide cross-functional access, ensuring all teams work from the same cost data.
How Workday helps implement activity-based costing.
Organizations use Workday Financial Management and Workday Adaptive Planning to support activity-based costing in complex, shared-services environments, gaining clearer visibility into how activities drive costs across products, services, and business units. By tracking activity drivers for different customer segments or service lines, finance teams make more informed decisions about pricing, service levels, and resource allocation.
Workday is particularly effective as a platform for ABC-style analysis because:
Multidimensional tagging enables costs to be analyzed by multiple lenses at once (for example, by project, customer, region, and product), supporting detailed profitability views
Flexible cost allocation and driver-based analysis help define and maintain cost pools and drivers as business models evolve
Integration with operational and financial systems supports more timely cost analysis, moving beyond purely periodic reviews
Dashboards, reports, and planning models provide multidimensional views of profitability and support predictive modeling of potential business changes
Because ABC-style insights are connected to Workday’s financial management and planning processes, finance teams can more easily translate cost transparency into budget adjustments, pricing strategies, and operational changes.
Learn about Workday Financial Management