What is Activity-Based Costing (ABC), and how does it work?

Activity-Based Costing is a method of costing that allocates overhead, and indirect costs for related products and services. This method of costing acknowledges the relationship between overhead activities and manufactured products. It assigns indirect costs less arbitrarily to products than traditional costing methods. Some indirect costs are hard to assign, like the salaries of office and management staff.

What is Activity-Based Costing?

ABC is mainly used in manufacturing because it improves the accuracy of cost data. It also helps to classify the costs that the company incurs during the production process.

This costing system can be used for target costing and product costing. It is also used to analyze product lines’ profitability, customer profitability, service pricing, and profitability. The activity-based approach is used by companies to better understand their costs and develop a pricing strategy.

The cost driver rate is calculated by dividing the total cost pool by the cost driver. In activity-based costs, the cost driver rate is calculated to determine overhead and indirect expenses related to an activity.

ABC Calculation:

  1. Identify the steps required to produce the product.
  2. Cost pools are a way to group all costs associated with a particular activity, such as manufacturing. Calculate the overhead for each cost pool.
  3. Cost drivers such as units or hours can be assigned to each activity.
  4. Calculate the rate of cost drivers by dividing the total overheads in each cost pool by the total cost drivers.
  5. Divide the total cost drivers by the total overhead for each cost pool to find the cost driver rate.
  6. Multiplying the cost driver rate with the number of cost drivers.

ABC Requirements

ABC is a cost accounting system based on activity, which can be defined as any event, unit of work, or task with a goal. For example, setting up machines for manufacturing, designing products, dispensing finished goods, or operating machines. Cost objects are activities that consume overhead resources.

A cost driver can be any transaction or event. Cost drivers, or activity drivers, are used to describe an allocation base. Cost drivers can include machine setups and maintenance requests, consumption power, purchase orders, or quality inspections.

Two categories of activity measurements exist duration drivers and transaction drivers. Duration drivers measure the length of time it takes an activity to complete.

The ABC system, unlike traditional cost measurement systems, which rely on volume counts, such as a machine or direct labor hours, to assign indirect costs to products, classifies five broad activity levels that are to some extent unrelated to the number of units produced. These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.