Activity-Based Costing (ABC) for SMEs: Is It Worth the Effort?

Traditional costing absorbs overhead based on a single base — usually direct labour hours or machine hours. That is fine when your product mix is simple. Activity-Based Costing (ABC) assigns overhead by what actually drives each cost — and it makes a real difference when your mix is anything but uniform.

The problem with single-base absorption

Imagine a small workshop making two products:

• Product A — simple, high-volume, long production runs, minimal setup
• Product B — complex, low-volume, frequent short runs, heavy setup

If you absorb overhead on labour hours and A takes more labour, A absorbs most of the overhead. But the real cost driver for overhead might be setups — and B has far more setups per unit than A.

Result: A looks expensive, B looks cheap. You over-price A and lose share; you under-price B and lose money. The cost system is lying to you.

What ABC does differently

ABC identifies the activities that drive overhead — setup, material handling, quality inspection, machine runs, design changes, customer servicing — and assigns the cost of each activity using a cost driver appropriate to it:

• Setup cost per setup
• Material handling per move
• Quality inspection per inspection
• Machine cost per machine hour

Each product then absorbs overhead based on how many of each activity it actually consumed.

The result is a cost per unit that reflects reality far better — products that demand more setups, more inspections, more handling carry more of the overhead.

A simple example

A workshop spends ₹2,40,000/month on overhead, of which:

• ₹60,000 is setup cost (driver: setups; total setups: 60)
• ₹60,000 is quality inspection (driver: inspections; total inspections: 120)
• ₹1,20,000 is general factory overhead (driver: labour hours; total hours: 8,000)

Activity rates:

• Setup: ₹1,000 per setup
• Inspection: ₹500 per inspection
• General: ₹15 per labour hour

Product A (10,000 units this month): 5 setups, 5 inspections, 6,000 labour hours. Overhead absorbed: ₹5,000 + ₹2,500 + ₹90,000 = ₹97,500 → ₹9.75/unit.

Product B (200 units this month): 55 setups, 115 inspections, 2,000 labour hours. Overhead absorbed: ₹55,000 + ₹57,500 + ₹30,000 = ₹1,42,500 → ₹712.50/unit.

If you had absorbed everything on labour hours, A would have carried ₹1,80,000 (75% of overhead) and B only ₹60,000 — a wildly different and wildly wrong picture.

When ABC is worth the effort for an SME

ABC takes work to set up and maintain. It is worth it when:

• Your product mix is diverse (simple and complex products side by side)
• Overhead is a large share of total cost (capital-intensive, automated, or service-heavy)
• You compete on price and pricing decisions are non-trivial
• Some products are suspected of cross-subsidising others

It is not worth it when:

• You make one product (or near-identical products in similar volumes)
• Overhead is a small share of total cost (material- or labour-heavy)
• The decisions ABC enables (pricing, mix, drop/keep) are not actively made

How to start small

Full ABC is a project. A simplified version captures most of the benefit with much less work:

• Identify your 3–5 biggest overhead pools (setup, handling, inspection, etc.)
• Pick one driver per pool (setups, moves, inspections, machine hours)
• Allocate the rest of overhead on a single base (labour or machine hours)
• Run it for one quarter alongside your traditional costing; compare results

Most SMEs find the simplified ABC tells them everything they need, without the maintenance burden of a full system.

The big payoff: pricing discipline

The most common reaction to a first ABC analysis is: "so these small custom orders have been losing money for years." That is the kind of insight that pays for the project on its own — and it only shows up when overhead is allocated by what actually drives it.

How Booksmor helps

Booksmor supports multiple absorption bases per cost centre — you can keep simple labour-hour absorption for one process and per-setup or per-inspection rates for another, then compare per-product cost across methods. Start a 30-day free trial and see whether your "expensive" products are really your most profitable.