Activity-based costing (ABC) is a type of costing method that sets and assigns overhead and indirect costs to interconnected products and services. Unlike traditional costing methods, this accounting method identifies the unseen connection between costs, overhead activities, and final manufactured products, and assigns indirect costs to products less arbitrarily. Yet, a few indirect costs, let’s say management and staff salaries, are tricky to assign to a product.
How does it work?
Activity-based costing (ABC) is usually used in the manufacturing industry because it makes cost data more reliable, thus showing the actual costs incurred during the production process.
Activity-based costing (ABC) costing system is used in:
1. Target costing
2. Product costing
3. Product line profitability analysis
4. Customer profitability analysis
5. Service pricing
Activity-based costing is used to obtain a more suitable understanding of costs, enabling companies to create a better and more appropriate pricing strategy.
The formula of activity-based costing (ABC)
The formula for activity-based costing is: the cost pool total divided by cost driver, which results in the cost driver rate. The cost driver rate is used to calculate the overhead and indirect costs.
The activity-based costing (ABC) calculation
- Identify every possible activity needed to complete the final product.
- Divide the activities into cost pools, including every individual cost associated with an activity (for example manufacturing cost is an individual cost). Now you can calculate the complete overhead of each cost pool.
- Set individual cost pool activity cost drivers (hours or units).
- Calculate the cost driver rate. For this, divide the total overhead in every cost pool by the total cost drivers.
- Now divide the entire overhead per cost pool by the total cost drivers. You will get the cost driver rate.
- Then multiply the cost driver rate with the number of cost drivers.
Activity-based costing (ABC) helps during the costing process by unveiling the number of cost pools which is crucial to analyzing overhead costs. It also makes indirect costs visible for some activities.
Requirements for activity-based costing (ABC)
The activity-based costing (ABC) system is a system of cost accounting based on activities — the activities include events, units of work, or tasks with a specific goal (like setting up machinery and tools for production, design, and the process of distributing finished goods). Activities use overhead resources, and thus, they are also cost objects.
Under the activity-based costing (ABC) system, activity is also any transaction that is a cost driver. The term cost driver (also known as an activity driver) refers to an allocation base. Here are some cost drivers:
- Purchase orders
- Consumed power
- Quality inspections
- Maintenance requests
- Machine setups
- Production orders
Categories of activity measures
There are two categories of activity measures:
Transaction drivers
Transaction drivers involve counting the number of times an activity occurs.
Duration drivers
Duration drivers measure how much time an activity takes to complete.
Unlike traditional cost measurement systems that rely on volume (machine hours, direct labor hours) to allot overhead costs to products, the activity-based costing (ABC) system categorizes five overall levels of activity that are not related to the number of units produced. The activity levels are:
1. Batch-level activity
2. Unit-level activity
3. Customer-level activity
4. Organization-sustaining activity
5. Product-level activity
The benefits
Activity-based costing (ABC) improves the costing process in many ways.
Activity-based costing (ABC) expands the number of cost pools used to gather overhead costs. Rather than collecting and accumulating all costs in one broad company-wide pool, ABC pools cost specifically by activity.
Instead of going by volume measures, such as machine hours or direct labor costs, activity-based costing (ABC) unveils new grounds for assigning overhead costs to entities where the costs are allotted based on activities that generate costs.
Activity-based costing (ABC) transforms the essence of several indirect costs. These costs once considered indirect (example: depreciation, utilities, or salaries would be traceable to certain activities when we use activity-based costing (ABC). Moreover, activity-based costing (ABC) also moves overhead costs from high-volume to low-volume products, thereby, raising the unit cost of low-volume products.
