Activity-Based Costing Explained: Method, Benefits, and Real-Life Example

What Is Activity-Based Costing (ABC)?

Activity-based costing (ABC) assigns overhead and indirect costs to products and services through activities, rather than traditional volume-based metrics. This method offers more accurate cost insights, helping businesses to refine pricing strategies and identify major cost drivers. ABC is especially beneficial in manufacturing for accurately tracing costs and understanding true product costs.

Understanding the Mechanics of Activity-Based Costing (ABC)

Activity-based costing is often used in manufacturing because it provides accurate cost data and helps classify production costs better.

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 the cost driver, which yields the cost driver rate. To find the cost driver rate, divide the total cost pool by the total cost drivers, which helps calculate related overhead and indirect costs.

The ABC calculation is as follows:  

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

As an activity-based costing example, consider Company ABC, which 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; in this example, this 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.

Key Requirements for Implementing 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.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders.

There are two categories of activity measures: transaction drivers, which involve counting how many times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count, such as machine hours and/or direct labor hours, to allocate indirect or overhead costs to products, the ABC system classifies five broad levels of activity that are, to a certain extent, unrelated to how many units are produced. These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.

Advantages of Adopting Activity-Based Costing

Activity-based costing (ABC) enhances the costing process in three ways. First, it increases the number of cost pools available to gather 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, so 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.

The Bottom Line

Activity-based costing (ABC) is a costing method widely used in the manufacturing industry. It assigns overhead and indirect costs to products and services by identifying specific activities as cost drivers. This method improves cost accuracy and helps companies develop better pricing strategies by recognizing and categorizing costs into activity levels: unit-level, batch-level, product-level, customer-level, and organization-sustaining activities. The true value of ABC lies in its ability to enhance cost classification and make indirect costs traceable to certain activities, ultimately giving businesses a clearer understanding of their true costs and enabling them to optimize processes for efficiency and cost reduction.