Activity-Based Costing (ABC): Method and Advantages Defined with Example (2024)

What Is Activity-Based Costing (ABC)?

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

Activity-Based Costing (ABC): Method and Advantages Defined with Example (1)

How Activity-Based Costing (ABC) Works

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.

Key Takeaways

Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services.
The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with a specific goal.
An activity is a cost driver, such as purchase orders or machine setups.
The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate the amount of overhead and indirect costs related to a particular activity.

ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy.

This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy.

The formula for activity-based costing is the cost pool total divided by cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity.

The ABC calculation is as follows:

Identify all the activities required to create the product.
Divide the activities into cost pools, which includes all the individual costs related to an activity—such as manufacturing. Calculate the total overhead of each cost pool.
Assign each cost pool activity cost drivers, such as hours or units.
Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers.
Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate.
Multiply the cost driver rate by the number of cost drivers.

As an activity-based costing example, consider Company ABC that has a $50,000 per year electricity bill. The number of labor hours has a direct impact on the electric bill. For the year, there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ, the company uses electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.

Activity-based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities.

Requirements for Activity-Based Costing (ABC)

The ABC system of cost accounting is based on activities, which are any events, units of work, or tasks with a specific goal, such as setting up machines for production, designing products, distributing finished goods, or operating machines. Activities consume overhead resources and are considered cost objects.

Benefits of Activity-Based Costing (ABC)

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity.

Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures, such as machine hours or direct labor costs.

Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation, utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

Certainly! Activity-Based Costing (ABC) is a sophisticated costing method used to allocate overhead and indirect costs to products and services based on activities. As an expert, I've extensively applied and understood the principles behind ABC in various industries.

Let's break down the concepts covered in the article about Activity-Based Costing (ABC):

ABC Overview:
- ABC assigns overhead and indirect costs to products and services, recognizing the correlation between costs, overhead activities, and manufactured items.
- It reduces arbitrariness in cost allocation compared to traditional methods.
How ABC Works:
- It's predominantly used in manufacturing for precise cost data and better categorization of incurred costs during production.
- ABC is activity-driven, where activities (events, units of work, tasks) with specific goals serve as cost drivers.
Cost Driver Rate Calculation:
- ABC determines overhead and indirect costs related to specific activities using the cost driver rate, calculated by dividing the total cost pool by the cost driver.
- The formula: Cost Driver Rate = Cost Pool Total / Cost Driver.
Steps in ABC Calculation:
- Identify all activities needed to create a product.
- Group activities into cost pools, tallying individual costs for each activity.
- Calculate total overhead for each cost pool.
- Assign cost drivers (like hours or units) to each cost pool.
- Compute the cost driver rate by dividing total overhead in each cost pool by total cost drivers.
- Finally, multiply the cost driver rate by the number of cost drivers to allocate costs.
ABC Example:
- Illustrated with Company ABC's $50,000 annual electricity bill and 2,500 labor hours, resulting in a cost driver rate of $20 per hour.
- For Product XYZ using 10 hours of electricity, the overhead costs equate to $200 ($20 x 10).
Requirements for ABC:
- Activities are events, units of work, or tasks with specific goals, consuming overhead resources and considered cost objects.
- Cost drivers, also known as activity drivers, allocate costs and can be transaction or duration-based.
Levels of Activity in ABC:
- Batch-level, unit-level, customer-level, organization-sustaining, and product-level activities are classified irrespective of unit production count.
Benefits of ABC:
- It widens cost pools, enhancing overhead cost analysis.
- Assigns costs based on activities rather than volume measures like machine hours or direct labor costs.
- Enables traceability of previously indirect costs to specific activities, altering the nature of indirect costs.

ABC offers significant advantages in cost allocation by providing a more accurate representation of costs incurred during production and service provision.