Why activity based costing? There are a number of shortcomings of the traditional cost systems. Let us illustrate this by an example. Let us assume that a company has three departments, Production, Materials and Sales. THe product manufactured could be four types of widgets, A,B.C and D.In the traditional cost model, a standard cost would be developed for the four widgets based on a standard capacity utilization. Costs of Materials and Sales department would be considered as overheads. These would then be allocated over products on a labour recovery method. The overheads are expressed as a percentage of labour costs. The assumption is that all overheads are similar and all overheads are uniformly incurred for the products and that they have a direct relationship with manufacturing time .These assumptions may not be true and leads to misleading results.

Sales is a resource. In the above example, let us assume that sales comprises of two departments. Channel management and marketing. If Marketing were running only a campaign for Product A , in that time period, all costs of marketing - the activity should be part of the cost of Product A. This will provide a more realistic view of the product profitability.

The only argument for traditional cost accounting is its simplicity. ABC is very complex. All activities and correlation with products are required to be mapped.This process will not only provide a more accurate view of profitability and how the resources are consumed, but also provide a window into wasteful activities.

This is how it contributes to the objective of lean manufacturing- eliminating waste.

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