The small number of full‐scale adoptions of activity‐based costing (ABC) coupled with ABC implementation failures have fueled a debate about the costs and benefits of ABC relative to more traditional volume‐based costing (VBC) systems. ABC differs from VBC by focusing attention on activities and resources that are under the control of multiple workers. Reducing these costs often requires a coordinated effort. Therefore, incentives that motivate workers to cooperate are a prerequisite to successful process improvements based on ABC. Alternatively, when competitive incentives are combined with ABC, the result can be unexpected and negative. We examine how accounting cost system and incentive structure choices interact. We find that profits are highest when ABC is linked with group‐based incentives, which provide high motivation to cooperate. In contrast, the lowest level of profit occurs when the same information‐rich cost system, ABC, is coupled with tournament‐based incentives. VBC, a cost system that provides a lower level of cost driver information, moderates the incentive effect. Thus, our results demonstrate that the effectiveness of ABC relative to traditional VBC is influenced by its interactive effect with incentive compensation.
