Which customers are the most profitable?
Which products are the least profitable?
Which are our best and worst sales or distribution channels?
How much of our activity is wasted?
Which activities can be reduced or eliminated without loss of service?

Activity based costing (ABC) can provide answers to these questions in a way that managers can understand, and which is supported by a methodology that is fair and justifiable.

The principle of Activity Based Costing is following:

 

	Identify the resources in the company which have a cost or financial value
	Identify activities that are undertaken within the company
	Determine how each type of resource is consumed by an activity and allocate the cost of these resources to each of the identified activities using a rational allocation method
	Identify the causal factor that drives each activity (the driver)
	Determine the volume of each driver associated with each customer, product, service or channel of distribution
	Allocate costs to customers, products, etc. on the basis of driver volumes

TERMS
RESOURCES: People, equipment & technology, space, supplies, capital as measured by hours, units, or dollars.
FUNCTIONS: Broad areas of related activities carried-out by a group of people with common responsibility. Examples: delivery, warehouse handling, outside sales, inside sales.
ACTIVITIES: A verb-noun description of what a department or function does. Multiple activities occur within functions and processes. Examples: deliver product, put-away product, make sales calls, take orders, attend meetings, receive training.
TASKS: Tasks are the steps necessary to perform an activity. An activity is ‘what’ a department does. A task is ‘how’ a department does it. Examples: load truck, fuel truck, drive to destination, unload truck, wait for check-in.
PROCESS: A collection of related activities operating under a set of procedures to accomplish a specific objective. Processes typically cut-across traditional functional lines to link together activities. Examples: processing a customer order, fulfillment, vendor order processing.
COST DRIVER: A factor that influences cost and may even cause costs. Activity cost drivers recognize the proportionate discharge of each activity cost into its cost objects such as customers or products. Examples: delivery cost is influenced by the number of stops, warehouse handling cost is influenced by number of pieces or and/or the cubic feet of pieces.
COST OBJECT: The entity that uses the activity. Examples: a customer, a product, a service, a product-line, and a vendor.