What is activity-based costing?

Activity-based costing (ABC) refers to a system that a company uses to determine production costs. ABC breaks down overhead costs between production-related activities to enable the company to clarify how resources are allocated.

Component	Description
Definition	Activity-Based Costing (ABC) is a cost accounting method that identifies and assigns costs to specific activities within an organization. It aims to provide a more accurate and detailed understanding of how resources are consumed by different processes and products. ABC differs from traditional costing methods by emphasizing the allocation of indirect costs based on activities and their drivers.
Purpose	The primary purpose of ABC is to improve cost allocation accuracy and enable better decision-making. It helps organizations allocate costs more precisely to products, services, or processes, leading to better pricing strategies, resource allocation, and cost control. ABC is particularly useful in identifying areas for cost reduction and process optimization.
Basic Principles	ABC is based on the following principles: – Identify Activities: Recognize all the activities involved in the production or delivery of products/services. – Assign Costs: Allocate indirect costs to activities based on resource consumption. – Determine Cost Drivers: Identify factors (cost drivers) that cause costs to vary within each activity. – Allocate Costs: Assign activity costs to products or services based on the usage of cost drivers.
Cost Hierarchy	ABC categorizes costs into four hierarchical levels: – Unit-Level Costs: Costs that vary with the production of each unit. – Batch-Level Costs: Costs related to activities performed for each batch of products. – Product-Level Costs: Costs associated with specific products or product lines. – Facility-Level Costs: Costs incurred at the organizational level, regardless of production volumes.
Benefits	– Accurate Cost Allocation: ABC provides more precise cost allocation to products or services. – Better Decision-Making: Helps in making informed decisions about pricing, product mix, and resource allocation. – Cost Reduction: Identifies cost-saving opportunities by revealing inefficient processes. – Process Optimization: Enables organizations to streamline activities and improve efficiency.
Challenges	– Complexity: Implementing ABC can be complex and time-consuming. – Data Requirements: It relies on accurate data and may require investments in information systems. – Resistance to Change: Employees may resist changes in cost allocation methods. – Costs of Implementation: The initial setup of ABC can be costly.
Applications	ABC is applied in various industries, including manufacturing, healthcare, finance, and services, where accurate cost allocation is critical for decision-making. Specific applications include: – Product Costing: Determining the true cost of manufacturing products. – Service Costing: Allocating costs in service-oriented businesses. – Process Improvement: Identifying activities that can be streamlined or eliminated. – Activity-Based Budgeting: Enhancing budgeting processes with activity insights.
Example	In a manufacturing company, ABC may reveal that a high-volume, low-margin product consumes a significant portion of machine setup and material handling activities. This insight can lead to pricing adjustments, process improvements, or even discontinuing the product.
Implementation Tips	– Start with a pilot project to understand the practical aspects of ABC. – Involve employees who have knowledge of the activities being analyzed. – Invest in data collection and management systems to support ABC. – Regularly review and update cost drivers and activity cost pools to reflect changing processes.

Table of Contents

Understanding activity-based costing

Manufacturers mostly use activity-based costing with complex production environments characterized by multiple machines, products, and processes

Businesses that use ABC cost and monitor internal activities which involves estimates of resource consumption and the cost of final outputs.

Resources are then assigned to activities and activities to cost objects based on these estimates.

Think of a cost object as any item for which a cost is separately measured. The most common cost objects are a company’s products and services because output cost is a key determinant in profitability and product pricing.

Activity-based costing was developed in the late 1980s by William S. Bruns and Robert S. Kaplan, with the latter also responsible for co-creating the Balanced Scorecard.

The method enables managers to better understand product and customer net profitability which can then be used to make effective, value-based decisions.

How is activity-based costing calculated?

Before we move on to an example calculation, let’s define the two terms briefly below

Cost pool

Cost pools encompass the various individual costs associated with an activity. In other words, they are the sum of activities that contribute to creating a product.

The total cost of these activities is the total overhead.

Cost driver

Cost drivers change or control the cost of an activity. There are two types:

Resource cost drivers – which drive resources to an activity or cost object and link recorded expenses to the activities performed. Examples include electricity, advertising, or even the total square feet occupied by an activity.
Activity cost drivers – these are specific activities that cause variable expenses. One variable expense can comprise multiple activity cost drivers. For example, the activity cost drivers for product manufacturers may include machine hours and labor hours.

When to Use Activity-Based Costing (ABC):

Activity-Based Costing is suitable in various business scenarios:

Complex Cost Structures: When an organization has complex cost structures that are not accurately captured by traditional costing methods.
Product or Service Diversification: In businesses with a wide range of products or services, where accurate cost allocation is essential for pricing and profitability analysis.
Process Optimization: When seeking opportunities to optimize processes and reduce costs by identifying resource-intensive activities.
Activity Cost Control: To control and manage costs at the activity level, enabling efficient resource allocation.
Customer Profitability Analysis: To understand the profitability of different customer segments by considering the cost of servicing each segment.

How to Implement Activity-Based Costing (ABC) Effectively:

To effectively implement Activity-Based Costing, consider the following steps:

Activity Identification: Identify and document all activities within the organization that consume resources.
Cost Pooling: Pool costs associated with each activity, categorizing them as direct and indirect costs.
Cost Driver Selection: Identify appropriate cost drivers for each activity to allocate costs accurately.
Data Collection: Gather data on resource consumption for each activity, either through direct measurement or estimation.
Allocation: Allocate costs to products, services, or projects based on the consumption of activities using the selected cost drivers.
Analysis and Reporting: Analyze the results and generate reports that provide insights into cost structures and profitability.

Drawbacks and Limitations of Activity-Based Costing (ABC):

While ABC offers precision in cost allocation, it also has drawbacks and limitations:

Complexity: Implementing ABC can be resource-intensive and complex, particularly in organizations with numerous activities.
Data Requirements: ABC relies on accurate data collection and can be challenging if data is incomplete or unavailable.
Subjectivity: The selection of cost drivers can involve subjectivity and judgment, affecting the accuracy of allocations.
Maintenance: Ongoing maintenance of the ABC system is required to ensure continued accuracy and relevance.

What to Expect When Using Activity-Based Costing (ABC):

When using Activity-Based Costing, expect the following outcomes and considerations:

Cost Precision: ABC provides more precise cost allocation, offering a better understanding of the true cost of products, services, or activities.
Profitability Insights: It enables organizations to identify profitable and unprofitable products, services, or customers.
Resource Optimization: ABC can highlight opportunities for resource optimization and cost reduction by targeting resource-intensive activities.
Initial Implementation Effort: The implementation of ABC may require significant effort and resources initially.

Related Business Frameworks:

Activity-Based Costing (ABC) is related to several business frameworks, including:

Cost-Volume-Profit (CVP) Analysis: ABC can complement CVP analysis by providing more accurate cost data for profit planning and pricing decisions.
Lean Six Sigma: ABC supports Lean Six Sigma efforts by identifying activities that can be streamlined or eliminated to reduce waste.
Total Quality Management (TQM): TQM initiatives benefit from ABC’s insights into the cost of quality and opportunities for improvement.
Strategic Cost Management: ABC aligns with strategic cost management approaches by enhancing cost transparency and cost control.
Value Chain Analysis: ABC contributes to value chain analysis by providing cost breakdowns at the activity level, aiding in identifying value-adding activities.

Activity-based costing example

To calculate activity-based costing, start by dividing the total cost pool by the cost driver to arrive at the cost driver rate.

To determine the overhead rate, multiply the cost driver rate by the number of cost drivers for each activity.

Consider a manufacturer with the following two activities and their costs:

Purchasing

$175,000 (total overhead for cost pool).
Number of purchase orders – 250 (cost driver).
Cost driver rate = 175000/250 = $700.
Overhead rate for 130 sales of Product ABC = 700 x 130 = $91,000.

Machinery (compressor) inspection

$110,000 (total overhead for cost pool).
Inspection hours – 1800 (cost driver).
Cost driver rate = 110000/1800 = $61.11.
Overhead rate for Compressor XYZ (375 inspection hours) = $61.11 x 375 = $22,916.25.

Key takeaways:

Activity-based costing (ABC) refers to a system that a company can use to determine production costs. ABC breaks down overhead costs between production-related activities to enable the company to clarify how resources are allocated.
Activity-based costing was developed in the late 1980s by William S. Bruns and Robert S. Kaplan. It enables managers to better understand product and customer net profitability and make better value-based decisions.
To calculate activity-based costing, start by dividing the total cost pool by the cost driver to determine the cost driver rate. The overhead rate can then be found by multiplying the cost driver rate by the number of cost drivers for each activity.