Activity-based costing systems and incremental costs

This article derives, in a comprehensive but informal way, the essential conditions for activity-based costing (ABC) and for costs proportional with output volume (CVO), such as variable material and component costs, to measure economic costs defined as incremental costs. Without this property these costing systems may give incorrect signals in decision making, such as in pricing, in altering the product portfolio, in make or buy and outsourcing decisions and in cost management. In contrast to the existing literature, these conditions are found to be extensive and to require a fairly detailed exploration of the complex and multifaceted nature of technology. Conditions on technology to allow the usual definition of cost pools are shown to require that production involves neither cost complementarities nor non-complementarities, that inputs in a cost pool are independent of those in other cost pools and that technology takes the form that the input mixes for a cost pool are fixed and invariant with volume. Essential conditions on the input market and the costing system are also considered. It will be indicated that a perfect market for inputs is required and that cost drivers are required to be linear homogeneous in the inputs in their cost pools. It is also shown that the type of cost function that can be entertained is restricted by those permissible technologies which allow incremental costs to be generated. These assumptions are thus imported into all the uses of these methods. Failure to satisfy these conditions suggests that many costs cannot be easily treated using ABC or CVO. Such failure also leads to distorting accounting numbers away from economic costs.