What is the Activity Based Costing? 

The ABC (Activity Based Costing) method of cost accounting pertains to a company's resource-consuming activities that create costs. It uses physical, monetary and non-monetary indicators to measure these costs and assumes a split variation of the total cost model, which imputes and distributes all of the costs among the company's products. 

It allocates all of a company's costs of operations to specific activities that the company carries out. In other words, the method assigns costs to services projects, products, acquisition, or tasks based on its activities and its resource consumption.

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How does Activity Based Costing Work? 

ABC applies to a company's main activities -- which are integral to the company's purpose -- and secondary activities -- (which generate added value for consumers but are usually subcontracted because they're too costly for the company to assume). This lets you know the amount and cost of each activity's resources. Specifically, ABC:

• Pays special attention to product planning and design costs
• Measures factors such as quality, delivery times, flexibility, innovation and after-sales service and contrasts these measures to traditional cost system operations
• Provides a more detailed and big-picture analysis of the cost-basis of activities than traditional systems.

After the company defines the tasks it performs, ABC determines how costs are distributed among the activities by analyzing inductors, which are factors influencing how much time, money and resources the activities consume. There are three such inductors:

• Transaction inductors, which consider how often an activity is repeated to calculate its average cost
• Inductors of duration, which tell how long it takes to perform each activity
• Inductors of intensity, which measure resource consumption every time an activity is performed.

ABC is superior to traditional cost quantification systems that focus on materials because it emphasizes activity costs and the added value activities bring to company products.

Activity-Based Costing Process

Activity-based costing focuses on identifying the activities required to make products, on forming cost pools for each activity, and on allocating overhead costs to the products based on their use of each activity. 

• Note: This is somewhat similar to the base allocation approach used in job costing - where specific activities are assigned a percentage of overhead and the overhead assigned to a job is based upon the amount of that activity undertaken. 

ABC systems and traditional systems often result in vastly different product costs. 

But even if the resulting product costs are not much different, ABC provides managers with a better understanding of the production activities required for each activity and the associated costs, which often leads to improved efficiency and reduced costs.

Identifying Activities

What are the five steps of activity-based costing?

Activity-based costing (ABC) uses several cost pools, organized by activity, to allocate overhead costs.

(Remember that plantwide allocation uses one cost pool for the whole plant, and department allocation uses one cost pool for each department.) 

The idea is that activities are required to produce products—activities such as purchasing materials, setting up machinery, assembling products, and inspecting finished products. 

These activities can be costly. Thus the cost of activities should be allocated to products based on the products’ use of the activities.

Total estimated overhead costs remain the same. However, the total is broken out into different activities rather than departments, and an overhead rate is established for each activity. 

The five steps are as follows:

Step 1. Identify costly activities required to complete products.

An activity is any process or procedure that consumes overhead resources. 

The goal is to understand all the activities required to make the company’s products. This requires interviewing and meeting with personnel throughout the organization. 

Companies that use activity-based costing may identify hundreds of activities required to make their products. 

The most challenging part of this step is narrowing down the activities to those that have the biggest impact on overhead costs.

Step 2. Assign overhead costs to the activities identified in step 1.

This step requires that overhead costs associated with each activity be assigned to the activity (i.e., a cost pool is formed for each activity). 

The cost pool for the purchasing materials activity will include costs for items such as salaries of purchasing personnel, rent for purchasing department office space, and depreciation of purchasing office equipment.

Remember, these are overhead costs, not direct materials or direct labor costs.

At this point, we have identified the most important and costly activities required to make products, and we have assigned overhead costs to each of these activities. 

The next step is to find an allocation base that drives the cost of each activity.

Step 3. Identify the cost driver for each activity.

A cost driver is the action that causes (or “drives”) the costs associated with the activity. 

Identifying cost drivers requires gathering information and interviewing key personnel in various areas of the organization, such as purchasing, production, quality control, and accounting. 

After careful scrutiny of the process required for each activity, the company will establish the cost drivers:

This information includes an estimate of the level of activity for each cost driver, which is needed to calculate a predetermined rate for each activity. 

Step 4. Calculate a predetermined overhead rate for each activity.

This is done by dividing the estimated overhead costs (from step 2) by the estimated level of cost driver activity (from step 3). 

This provides the overhead rate calculations for the  Company for each activity. 

Step 5. Allocate overhead costs to products.

Overhead costs are allocated to products by multiplying the predetermined overhead rate for each activity (calculated in step 4) by the level of cost driver activity used by the product. 

The term applied overhead is often used to describe this process.

The bottom shows the overhead cost per unit for each product. 

This information is needed to calculate the product cost for each unit of product, which we discuss next.

How are overhead costs recorded when using activity-based costing?

We presented the flow of costs for a job costing system, including how to track actual overhead costs and how to track overhead applied using a separate manufacturing overhead account. 

The cost flows are the same for an activity-based costing system, with one exception. Instead of using one plantwide overhead rate to allocate (or apply) overhead to products, an ABC system uses several overhead rates to allocate overhead. 

The entry to record this allocation—whether it involves one rate or multiple rates—is the same. 

Simply debit work-in-process inventory and credit manufacturing overhead for the amount of overhead applied. 

(Some companies use separate work-in-process inventory and manufacturing overhead accounts for each activity. For the sake of simplicity, we do not use separate accounts.)

Recall from that the manufacturing overhead account is closed to cost of goods sold at the end of the period. 

If actual overhead costs are higher than applied overhead, the resulting underapplied overhead is closed with a debit to cost of goods sold and a credit to manufacturing overhead. 

If actual overhead costs are lower than applied overhead, the resulting overapplied overhead is closed with a debit to manufacturing overhead and a credit to cost of goods sold.

Service Organization and Activity-Based Costing

The same five steps used in manufacturing organizations can also be used in service organizations. To understand how ABC could be used in a service organization.

The five steps of activity-based costing we presented earlier still apply. Let’s look at how these steps might work when evaluating the cost of bank loans.

Step 1. Identify costly activities.

Processing loans includes activities such as meeting with customers, reviewing customer applications, and running credit reports.

Step 2. Assign overhead costs to the activities identified in step 1.

Costs assigned to the activity of reviewing customer applications include items such as wages of personnel reviewing applications, depreciation of computer equipment used to review online applications, and supplies needed for the review process.

Step 3. Identify the cost driver for each activity.         

Step 4. Calculate a predetermined overhead rate for each activity.

This is done by dividing estimated overhead costs for each activity by the estimated cost driver activity. 

Step 5. Allocate overhead costs to products.

Overhead is allocated, or applied, to products (auto loans and home equity loans in this example) based on the use of each activity’s cost driver.

Related Topics

• Job Costing vs Process Costing
• Assign Direct Material and Direct Labor to Job
• Assign Manufacturing Overhead Costs to Job
• Assign Overhead Costs to Products
• Plantwide Cost Allocation
• Department Cost Allocation
• Activity-Based Costing
• Weighted-Average Cost of Products
• Production Cost Report
• Fixed, Variable, and Mixed Cost Estimations
• Contribution Margin Income Statement
• Cost-Volume-Profit Analysis
• Margin of Safety
• Contribution Margin per Unit of Constraint
• Absorption Costing vs Variable Costing
• Differential Analysis and Decisions
• Cost Decisions for Joint Products
• Capital Budgeting
• Life Cycle Costing
• The Master Budget
• Activity-Based Budgeting
• Standard Costs
• Imputed Value
• Variance Analysis for Product Costs
• Absorption Pricing
• Price Variance
• Absorption Variance 
• Responsibility Centers
• Comparing Segmented Income
• Using ROI to Evaluate Performance
• Using Residual Income to Evaluate Performance
• Use Economic Value Added to Evaluate Performance
• Transfer Pricing