Understanding costs: Part 2 — resource-based costing

A new approach to costing relies on an integrated approach to looking at costs, resources, activities, and cost objects — leading to insight for strategy and operations.

Editor's note: This article is the second in a two-part series looking at costs. It proposes a comprehensive — resource-based — approach to costing and follows an overview of traditional and activity-based costing approaches in part one.

In the first article in this series, we looked briefly at the development of costing approaches and the current shortfall in cost analysis capability, principally due to the scope of the approaches. A key conclusion from that article was that to improve costing capability it is imperative to understand each stage — from raw costs through resources acquired, activities completed, and finally to the ultimate cost objects (see the chart  "Evolution of Costing Approaches").

Evolution of costing approaches

This second part of the series takes the various characteristics required for a better costing methodology and then sets out a proposed approach that meets these requirements in a way that is more suited to the organisation of today and the future.

An effective costing system has the following characteristics:

  • Enables analysis of historical costs and drivers.
  • Shows linkages between costs, resources, activities, and cost objects.
  • Predicts future costs and drivers.
  • Provides appropriate level of detail.
  • Maps the path from current to future state.
  • Is produced on a regular and timely basis.
  • Achieves end-user credibility.

Resource-based costing

The proposed approach, referred to as "resource-based costing", enables and meets the needs of today's organisations. The key differentiator of this approach is the level of detail gathered on resources, including their quantities and characteristics. This enables the derivation of further insight such as the resource unit cost and resource consumption rates by resource and activity types. The approach facilitates a more logical allocation of costs to activities and provides valuable insight for operational and strategic management.

Under the resource-based costing approach, the key allocation stages are:

  1. Costs are initially linked specifically to the resources acquired (resource cost pools).
  2. Resources are then allocated to the activities that consume them (activity cost pools).
  3. Finally, the activities are allocated to cost objects.

This business modelling approach can be more complex to develop and maintain but far better informs financial, operational, and strategic organisational management. The rest of this article provides a brief overview of the proposed approach.

Available and required data

The first consideration before starting to build the costing system is to understand the level of detail that is required in the information to be provided. The level of detail available at the end of the third and final allocation stage, showing the split by cost object, will be determined largely by the lowest level of detail that is used across all three stages. For example, if average staff costs are used instead of the specific costs of a staff member, then the information will not be precisely correct, but it will still provide powerful insight.

The level of detail will often be determined by the needs of operational managers. For instance, they will want to understand performance levels for each individual team member on a timely and frequent basis. However, strategic management would not require this level of detail. Additionally, the level of required detail will differ for analysis of actual performance and for prediction of future performance. It's essential that both operational/strategic and actual/predicted data is integrated to ensure decision-making is aligned across these views. With digitalisation, several organisations are finding that their operational and strategic planning cycles are happening more frequently and even starting to merge into one exercise, which demonstrates the need for an integrated approach.

It is generally best to capture raw data at the lowest reasonable level of detail and then apply any aggregations, as required, within the subsequent stages of analysis.

We will now look at the allocation stages in more detail (see the chart "Resource-Based Costing Approach").

Resource-based costing approach<

Step 1: Allocation of costs to resources

The initial step in this stage is to identify the different resource types and determine at what level of granularity they will be captured.

Then the resources need to be separated into primary and secondary resources. Primary resources are those that directly complete activities, such as staff, outsourced suppliers, and robots. Secondary resources are those that enable the primary resources to complete those activities and are likely to include office space, personal computers, stationery, telephone networks, and utilities. All secondary resources and their associated costs need to be allocated to a primary resource or resources.

Thirdly, to consider capacity management issues, it is necessary to determine the degree of variability of supply levels for each resource, with a categorisation into "committed" or "flexible" resources.

Most organisational resources tend to be committed, which means they have been acquired through some form of contractual arrangement. Payments in advance are made to gain capacity in these resources, to ensure they are available to complete the activity to satisfy the anticipated level of demand. Examples would include permanent staff, buildings, and equipment. Some of these resources may be referred to as being fixed, but it is likely they will be variable in the longer term. Expense for these resources is incurred regardless of their level of utilisation.

Then there are flexible resources, which are generally those provided by external suppliers. Examples would include temporary staff, electricity supplies, telephone calls, and travel costs. Payment is only made for utilised resources, and there will generally be no unused capacity. The capacity of these resources will be variable in both the short and long term, subject to the suppliers' capacity to meet demand.

Having allocated costs to resources, in this stage the final step is to identify the number of units of resource acquired and then derive a unit cost for each resource type.

We can now move onto the next stage, which is to analyse how resources are consumed by activities and identify any surplus or shortfall in committed resources.

Step 2: Allocation of resources to activities

The various organisational activities need to be identified, classified as direct or sustaining, then have resources allocated to them.

Direct activities should be seen as value-adding to the individual customer and, hence, justify any charges that are applied. They include service provision, product production, after-sales service, customer projects, and relationship management.

Alternatively, activities may be sustaining, as they are enabling the organisation to exist and to provide their offering to customers (see the table below providing examples of sustaining activities). If these activities are not completed, the organisation may cease to be an ongoing operation.


If utilisation levels are lower than anticipated, there are likely to be some unutilised resources or excess capacity. This unutilised capacity can be eliminated by increasing demand for activities to be completed or by reducing resource supply. In the meantime, manufacturing businesses may usefully employ excess capacity to build up stock levels, but this is not an option in service industries. On the other hand, when demand levels exceed expectations, they will create bottlenecks, shortfalls in stock, increased pace of activity, delays, or potentially lead to an inferior quality of work. Organisations may plan to maintain an intentional oversupply of resources to avoid an impact on service levels. The existence of any resource with no surplus capacity is a warning sign that demand is at or possibly in excess of capacity, which could flag issues with service levels.

Improved demand forecasting enables better capacity management and the opportunity to minimise surplus resource costs. However, some level of surplus resources may still be required to maintain the desired service levels to cover for any residual level of uncertainty in demand forecasts.

Step 3: Allocation of activities to cost objects

In the final stage, activities are related to cost objects. Those relating directly to products, services, or customers will vary directly with customer demand. However, sustaining activities will tend to mainly increase with levels of organisational complexity rather than customer demand.

When organisations have a high level and cost of sustaining activities with a low marginal cost to satisfy additional customer demand, then they may pursue a relentless growth strategy combined with tight control over sustaining activities. Conversely, when a business has relatively low costs of sustaining activities and high marginal cost for customer demand, then focus may shift to profitable satisfaction of target customers.

By this stage the full path of cost drivers has been defined, and the costs can be related to income to provide an insightful view of the profitability dynamics.


The right approach for your organisation will be a compromise between your organisation's needs, what is feasible to be delivered, and the cost. The reality is that probably no allocation approach will be totally accurate, but the right approach can give directionally correct information to better inform decisions. It should always be kept in mind that it is far better to be approximately right rather than exactly wrong.

Paul Ashworth, FCMA, CGMA, is a Jersey, British Isles-based practising management accountant providing strategic insight and enabling business intelligence systems in financial and business services, and public sector organisations. To comment on this article or to suggest an idea for another article, contact Drew Adamek at