Activity-based Costing for the Small Business: A Primer.

If accurate product costing, more flexible capacity use, and better information for strategic planning and decision making appeal to you, ABC is the supplement to use with traditional accounting methods.

Understandably, entrepreneurs and owners of small firms are not likely to give much thought to an accounting system during the planning or implementation phases of their business. The business plan forces them to deal with pro forma financial statements that are properly integrated to assist bankers and venture capitalists in evaluating the venture.

Soon after start-up, however, these entrepreneurs and small business owners will be faced with the need for an accounting system to meet the ongoing information needs of the investors, the lenders, and the various authorities that will tax the income of the business. An accounting system that meets those needs is one that is governed, to a great extent, by the demands of the Financial Accounting Standards Board (FASB), in the case of information provided to investors and lenders, and by the Internal Revenue Service, in the case of information provided for income tax purposes.

Accounting systems designed to meet the needs of investors, lenders, and income taxing authorities often fail to provide the managerial accounting information necessary to operate the new venture. In particular, they do not provide the information needed to accomplish the very important tactical and strategic planning and decision making that will be critical to success.

Traditional Accounting Systems

The term "traditional' is used to describe the accounting system designed primarily to meet the needs of investors, lenders, and income tax authorities. Such a system is characterized by absorption costing. Absorption costing takes its name from the manner in which inventory is valued for reporting on the balance sheet and the cost of goods sold is valued for reporting in the income statement--in other words, the manner in which products "absorb" cost as they are manufactured.

It is based on the assumption that as a product is manufactured, it absorbs the costs of the direct materials that become a part of it, the labor used in making it, and the overhead costs associated with its production, which include depreciation on the machinery and the facilities, supervisory costs, heat and electricity, and many other costs related to operating the firm. The assumption behind absorption costing is that these expenses are necessary for the product to be manufactured, so each should attach itself to, or be absorbed by, the product being manufactured.