Activity Based Costing

Activity Based Costing (ABC)


  • ·        Activity based costing (ABC) is a method of assigning indirect costs to products and services based on the activities they require.  ABC is a two-stage process in which indirect costs are first assigned to activities and then to individual products and services based on their activity requirements.


  • o       Stage One:  Assign Indirect Costs To Activities
    • §        Identify and Classify Activities – The first step in an ABC system is to identify the activities required to make the product or provide the service.  Activities can be classified by the following methods:
      • ·        Facility or Company-wide activities – these are activities that support the entire company.
      • ·        Product or Customer activities – these are activities that relate to a specific product line or customer.
      • ·        Batch activities – activities performed for a group of units all at once.
      • ·        Unit activities – activities that must be performed for each individual unit.


  • §        Form Activity Cost Pools and Assign Indirect Costs to Each Activity – When the activities have been identified and classified (facility, product, batch, unit), the next step is to combine similar activities into activity cost pools.  To keep the cost system manageable, we must simplify the number of activities by grouping like or similar activities together.  The goal is to create as few cost pools as possible while still capturing the major activities identified in the previous step.  When allocating costs to each activity, one will need to come up with a uniform cost drivers (Stage one allocation cost drivers such as supervision hours, machine hours) that relate to each activity.  We will talk about this in Stage Two.


  • o       Stage Two:  Assign Activity Costs to Individual Products or Services


  • §        Select an Activity Cost Driver for Each Cost Pool – The next step is to select an activity cost driver for each of the activity cost pools.  An activity cost driver is a measure of the underlying activity that occurs in each activity cost pool.  The goal is to identify a driver that has a cause-and-effect relationship with the underlying activity. 


Unlike traditional cost systems which rely on strictly volume based allocation measures, ABC systems include measures that capture something other than the sheer volume of units produced or customers served.  These measures are called non-volume based cost drivers. Here are some examples:

  • ·        Volume Based Allocation Measures – Number of units produced, number of direct labor hours, number of machine hours, direct materials costs (used in traditional cost systems)
  • ·        Nonvolume Based Cost Drivers – Number of batches or setup time, processing time per unit number of quality inspections, number of design changes (used in activity based costing systems)


These drivers can be both volume based and activity based at the same time.  One needs to choose the appropriate activity (machine hours (volume activity), Setup time (activity based), direct labor hours (volume activity), and quality inspections (activity based)) that best describes the activity pool.  These cost drive are called Stage 2 cost drivers; they can have volume and nonvolume based cost drivers that represent the cost in the activity cost pools.


  • §        Assign Indirect Costs to Products of Services Based on their Activity Demands – The next step is to assign the costs from the activity cost pools to the individual products using the Stage 2 activity drivers.  Two methods can be used to assign indirect costs to individual products or services based on their activity requirements:  the activity rate method and the activity proportion method.  These two methods are mathematically equivalent and will provide identical results as long as there are no rounding errors in the rates or proportions.  The method used depends on the type of information provided and whether complete information on all product or service lines is available.


  • ·        Activity Rate Method – This method involves computing an activity rate that is very similar to calculating a predetermined overhead rate, except that now we have an activity rate for each activity cost pool.


  • ·        Activity Proportion Method – This method for assigning activity costs to individual products is by calculating activity proportions or percentages.


To complete the Stage 2 ABC allocations, we need to add the cost of all four activities for each product line, and they should equal the total manufacturing overhead.  To calculate the manufacturing overhead cost per unit, we need to divide the total manufacturing overhead (for each product) by the number of units (for each product).


  • o       Comparison of Volume-Based and Activity Based Cost Systems – Activity based costing allows for a more allocation of indirect costs that the traditional volume based costing system.  This is crucial to allocate costs appropriately for not only reporting purposes, but for the accurate pricing of products.  Products can be undercosted or overcosted under traditional overhead allocation systems.  Traditional allocation systems (direct labor hours) cause distortions in costs and prices simply due to the amount of hours used to make a product versus the activities that cost the most (quality inspections) which can be the real cost driver. Products could then be overpriced or underpriced in the marketplace, which could affect sale volumes for the product and overall profitability of the firm.


  • o      Calculation of Total Manufacturing Cost and Gross margin – The only difference between ABC and traditional cost systems is the treatment of indirect costs, or manufacturing overhead.  To compute the full manufacturing costs, we still need to add the direct materials and direct labor costs, which do not change as a result of the cost allocation method used.


Traditional cost systems tend to undercost low-volume products and overcost high volume products.  By focusing strictly on volume, traditional costing systems do not take into account other factors that drive cost, such as the complexity of the production process or the additional setup, design, and quality control activities required by newer or more innovative products.