Understanding the ABC method and its advantages

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The ABC method, also known asActivity-Based Costing, is a cost management technique used to analyse and understand the full costs associated with a company’s various activities.

It differs from the traditional approach to cost analysis by focusing on the precise definition of costs for each category of activity, rather than simply assigning costs to profit or cost centres.

In this article, we will outline the key principles of the ABC method and the benefits it can bring to your business!

ABC (Activity Based Costing): Definition

The ABC method is an activity-based approach to costing, segmenting a company’s operations for a detailed analysis of expenditure in each section. This method breaks down activities to assess the associated costs (such as products, raw materials and customers) which in turn use resources within the business.

This process involves organising activity costs based on the Pareto principle (80/20 rule): 80% of sales are generated by 20% of products. In this way, the ABC method makes it possible to focus first on the elements that contribute to 80% of revenues.

What is the objective of the ABC method?

Its main objective is to structure costs by activity or process for optimised management, which is particularly relevant in areas with high indirect costs.

By focusing on activities rather than cost centres, the ABC method providesmore accurate and relevant information on costs incurred. This makes it much easier to take financial management decisions.

Precise knowledge of the costs associated with different activities makes it possible toidentify unprofitable activities and take steps to reduce or eliminate these costs. In this way, the ABC method can help to increase your company’s overall profitability.

What’s more, identifying and analysing your various activities gives you aclear picture of the purchasing processes in place in your company, making it easier to improve and optimise them.

The steps involved in carrying out an ABC analysis

The first step is to determine the different activities carried out within the company. These activities are often grouped into “processes” or “functions”, such as production, logistics or customer service.

Once the activities have been identified, the next step is to classify the costs associated with each of them. There are generally three main types of cost: direct costs (those that can be directly attributed to a particular activity), indirect costs (those that cannot be directly attributed to an activity, but are nonetheless related) and fixed costs (those that remain constant regardless of changes in activities).

For each cost category identified, it is then necessary to determine the quantity of resources required to carry out the activities concerned. This may include, for example, staff time, energy consumption or raw material costs.

Finally, by bringing together all the information gathered above, it is possible to calculate the full cost of each activity. This cost includes not only the direct costs, but also the indirect and fixed costs associated with it.

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Purchasing classification

The ABC classification method is structured as follows:

  1. Class A: This category includes the most strategic purchases, accounting for 80% of total purchasing costs, although they only come from 20% of suppliers. Purchases in this category are therefore essential and must be managed with the utmost care.
  2. Class B: Purchases in this category account for 15% of total purchasing costs, sourced from 30% of suppliers. Although less critical than class A, these purchases are still significant and require careful management.
  3. Class C: This last category concerns the least impacting purchases, accounting for only 5% of total costs, but coming from half the suppliers. Although these purchases have a lower priority, they nonetheless contribute to overall operations and merit appropriate monitoring.
Segment % of sales
of number of
suppliers
A 80% 20%
B 15% 20%
C 5% 60%

This structure will enable you to understand and prioritise types of purchase according to their financial impact, thereby optimising the management of resources and suppliers.

Who is this method designed for?

The ABC method is recommended for companies with repetitive processes. This profile covers a wide range of companies in various sectors, as repetitive processes are common in many industrial and commercial activities.

This method is particularly relevant for these companies, as it enables costs and expenses to be managed more effectively. By providing a detailed analysis of the costs associated with each activity, the ABC method helps to identify areas where savings can be made and processes optimised.

Managers and decision-makers within these companies find the ABC method a valuable tool for making strategic decisions. With better visibility of the real costs associated with each process and activity, they can prioritise investments, identify opportunities for improvement, and allocate resources more effectively.

Advantages and limitations of the ABC method

Benefits for your company

The ABC method allows precise allocation of costs to products and avoids arbitrary allocation of indirect costs using imprecise measurements.

It also provides an in-depth understanding of the company’s internal processes, enabling strengths and weaknesses to be identified and informed decisions to be taken.

The limitations of this method

Although the ABC method has many advantages, it also has a number of disadvantages.

Firstly, implementing the ABC method can be complex, particularly when it comes to identifying activities and categorising costs. It is therefore essential to train your team members in this technique and to apply it rigorously.

Secondly, collecting and analysing the data required to apply the ABC method can represent a significant investment in terms of time and human resources. However, the potential gains in terms of profitability and process improvements often justify this initial effort.

To overcome these limitations, here are a few good practices to adopt:

  • Use cost management software such as Weproc to facilitate data collection and analysis, as well as the monitoring of activities and associated costs.
  • Conduct regular reviews of costs and activities to ensure that the information collected is accurate and relevant to your business.
  • Involve your team members in the process of identifying activities and categorising costs to increase their commitment to and understanding of the ABC method.

 

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