A Simple Analogy
The objective of ABC is to derive improved measures of cost. A simple analogy might be helpful in showing how ABC can achieve this outcome.
Suppose you have two one-gallon pitchers filled with tea, one sweetened and one unsweetened. You desire to fill a pint glass with 75% sweetened and 25% unsweetened tea. You have an empty pint glass and it has no markings indicating fluid level. Is it possible for you to pour from the pitchers to the glass and achieve your special blend (no mixing within the pitchers is allowed)? About the best solution you can reach is based on guesswork.
Now, assume you also have an empty cup (remember, two cups make a pint). You now have the added tool necessary to solve your problem and get the desired blend. For instance, you could (a) pour a cup of sweetened tea and transfer it to the glass, then (b) pour a cup of unsweetened and transfer it to the glass, then (c) shake the glass to achieve a 50/50 mix, then (d) pour a cup of the 50/50 mix from the glass back into the cup, then (e) top off the half-full glass of 50/50 mix with sweetened tea, and (f ) shake the glass to achieve the 75/25 mix.
With the tea example, we see that the introduction of an intermediate container (cup) enables the correct allocation of the resource (tea) to the end object (glass). The analogy to ABC is that by introducing activity cost pools (the intermediate cup) we are better able to allocate the costs (resources) to end objects (products, customers, etc.). Without the activity cost pool, it becomes difficult/impossible to make a connection between each resource consumed and each end object.
A Case Study in ABC
Enough general discussion on ABC, it is now time to consider a comprehensive illustration.
David Eng enjoys portable digital music players and golf. However, he was frustrated because the cord for his digital music player interfered with his golf swing. This modern problem prompted him to form the Golf and Music Enthusiast Company (GAME).
GAME developed two specialized products. The first product is GLASSESong, a pair of sunglasses with a built in music player and very short cord to the earbud speakers. The other is CAPlayer, a golf cap with a built in music player having a very short unobtrusive cord from the cap to the speakers.
GAME has been employing traditional costing methods, and applies factory overhead on the basis of labor costs. The products sell as fast as they can be produced so there is virtually no inventory. CAPlayer has sold 900,000 units and GLASSESong has sold 1,100,000 units. Each unit sells for $60. David Eng's new frustration is with the CAPlayer. It is reportedly much more expensive to produce than GLASSESong. Following is an analysis of GAME's cost of production by product:
Sales totaled $120,000,000 ((900,000 + 1,100,000) X $60), and selling, general and administrative costs totaled $6,000,000. The result is that
GAME generated a $4,000,000 profit, computed as follows:
Despite the overall profit, the per unit cost data suggests that the CAPlayer is losing money because the $60 per unit sales price is below the $64.44 per unit cost. David Eng has employed a cost consultant to review GAME's costing techniques and identify why the CAPlayer is so expensive. The consultant has returned a management report suggesting that the CAPlayer is actually much more profitable than GLASSESong. The consultant employed ABC in reaching this conclusion. Below is a review of the methods employed by the consultant: