Question

How is activity based costing used to measure customer profitability and why does it need to be tracked by customer?

Answer 1

First of all let's understand what activity based costing means : Activity Based costing is that costing method which identifies the different types of activities/services within the organization and assigns the cost of each such activity to the products/services offered by the company. It assigns the overheads and indirect costs to its relative product or services. It enhances the reliability of the data and provides a better classification of the costs. It is mostly used in the manufacturing industries.

Now that we have understood what activity based costing means, let's discuss how it is used to measure customer profitability and why does it need to be tracked by customer : Activity based costing helps to organize the costs related to the customers into different pools by using different types of cost drivers which greatly helps the company in determining the costs for each customer and thereby also helps in calculating the profitability of each such customer. Instead of cost drivers, sometimes, some cost allocation bases might also be used. Analyzing customer specific Selling and Marketing Expenses by using this costing method will enable the company to determine the unprofitable customers and thereby improve the profitability of the company by helping the company to eliminate such unprofitable customers.

It is also important to track it by customer as understanding the true costs of serving a specific customer is also very important for any organization as it essential for managerial decision making and provides valuable information needed to make successful managerial decision to improve overall organizational profitability.