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.
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.
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.
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Gennaro is the creator of FourWeekMBA, which reached about four million business people, comprising C-level executives, investors, analysts, product managers, and aspiring digital entrepreneurs in 2022 alone | He is also Director of Sales for a high-tech scaleup in the AI Industry | In 2012, Gennaro earned an International MBA with emphasis on Corporate Finance and Business Strategy.
