What is activity‑based costing (ABC)?
– Activity‑based costing (ABC) is a method for assigning overhead and other indirect costs to products or services by linking those costs to the specific activities that consume resources. Rather than allocating overhead using a single volume measure (like machine hours or direct labor hours), ABC builds multiple activity cost pools and assigns costs using measurable “cost drivers” (the events or measures that cause the cost).
Key terms (defined on first use)
– Cost pool: a grouped collection of costs associated with performing a particular activity (for example, equipment power or order processing).
– Cost driver (activity driver): the measurable event or quantity that causes costs in a cost pool (for example, labor hours, machine setups, purchase orders, or hours of support).
– Transaction driver: a cost driver that counts how many times an activity occurs (e.g., number of inspections).
– Duration driver: a cost driver that measures how long an activity takes (e.g., setup minutes).
How ABC works — step‑by‑step
1. Identify activities. List the discrete tasks or events that consume resources (e.g., machine setups, inspections, customer support).
2. Group costs into cost pools. Aggregate overhead costs by activity (one pool per activity or activity group).
3. Select cost drivers. Choose the measurable base that best explains consumption of each pool (transaction or duration drivers).
4. Calculate cost‑driver rates. For each pool, divide the total cost in the pool by the total driver units:
– Cost driver rate = Total cost in cost pool / Total cost driver units
5. Assign overhead to cost objects. Multiply each rate by the driver units consumed by a product, batch, or customer to allocate overhead.
6. Sum direct costs and allocated overhead to compute full product or service cost.
Checklist for implementing ABC
– Map key activities that consume resources.
– Create separate cost pools tied to those activities.
– Choose drivers that have a strong causal link to each pool (transaction or duration measures).
– Collect reliable counts or time data for drivers.
– Compute driver rates and test allocations for reasonableness.
– Use results to analyze product, batch, or customer profitability and to guide pricing or process-improvement decisions.
– Plan for ongoing data collection and periodic review (ABC requires maintenance).
Five levels of activity (useful for classification)
– Unit‑level: Performed for each unit produced (e.g., power consumed to run a machine per item).
– Batch‑level: Performed each time a batch is produced, regardless of units in the batch (e.g., setting up equipment for a production run).
– Product‑level: Activities tied to a specific product line, required regardless of production quantity (e.g., product design).
– Customer‑level: Activities required to serve particular customers (e.g., dedicated technical support).
– Organization‑sustaining: Costs of running the organization that are not driven by a specific product, batch, or customer (e.g., general plant security).
What ABC seeks to identify
– The method aims to reveal which activities drive the most cost (the top cost drivers), making previously indirect costs more traceable to the causes of consumption and exposing inefficiencies or mispriced products.
Simple numeric example (worked)
Situation:
– Annual electricity bill allocated to manufacturing activities: $50,000.
– Total labor hours for the year (chosen as the cost driver): 2,500 hours.
– Product XYZ uses 10 labor hours of electricity‑consuming activity.
Steps and calculation:
1. Compute cost driver rate:
– Rate = $50,000 / 2,500 hours = $20 per labor hour.
2. Allocate overhead to Product XYZ:
– Overhead = $20/hour × 10 hours = $200.
Interpretation:
– Under ABC, the electricity cost is allocated based on the activity that consumes it (labor hours), giving Product XYZ an additional $200 of overhead for the electricity pool.
When to use ABC and what it helps with
– ABC is particularly useful when a firm has diverse products, many indirect costs, or variation in resource consumption across products or customers. Common applications include product costing, product‑line profitability analysis, customer profitability analysis, and service pricing. By increasing the number of cost pools and choosing drivers tied to real activities, ABC can produce more accurate unit costs than simple volume‑based allocations.
Practical notes and assumptions
– ABC produces better cost insight only if activities and drivers are correctly identified and reliably measured.
– Implementation requires collecting activity data; therefore, there are setup and maintenance costs.
– ABC can shift overhead from high-volume products to low-volume products because it allocates costs according to activity usage, not just production volume.
Sources for further reading
– Investopedia — Activity‑Based Costing (ABC): https://www.investopedia.com/terms/a/abc.asp
– Harvard Business Review — Time‑Driven Activity‑Based Costing (Kaplan & Anderson): https://hbr.org/2004/11/time-driven-activity-based-costing
– CGMA — Activity‑Based Costing (resource page): https://www.cgma.org/resources/tools/essential-tools/activity-based-costing.html
– AccountingTools — What Is Activity‑Based Costing?: https://www.accountingtools.com/articles/what-is-activity-based-costing.html
Educational disclaimer
This explainer is for educational purposes only and does not constitute individualized accounting, tax, or investment advice. For specific implementations or decisions, consult a qualified accountant or financial professional.