Activity-Based Costing (ABC)

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Activity-Based Costing (ABC)

What is ABC?

Activity-Based Costing (ABC) assigns overhead and indirect costs to products and services by tracing those costs to the specific activities that consume resources. Unlike traditional volume-based allocation (e.g., machine hours or direct labor), ABC uses multiple activity-based cost pools and cost drivers to produce more accurate product and service costs. It is especially useful in manufacturing and service environments with diverse products or complex overhead structures.

Why use ABC?

  • Produces more accurate product and customer costs.
  • Reveals true cost drivers (e.g., setups, inspections, purchase orders).
  • Supports better pricing, product mix, and process-improvement decisions.
  • Makes many previously “indirect” costs (utilities, depreciation, salaries) traceable to activities.

Core mechanics and formula

ABC requires:
1. Identifying activities required to produce a product or deliver a service.
2. Grouping related costs into cost pools (one pool per activity or activity group).
3. Selecting cost drivers for each pool (an allocation base that measures activity consumption).
4. Calculating a cost driver rate and applying it to products or customers.

Basic formula:
– Cost driver rate = Total cost in a cost pool / Total quantity of the cost driver
– Allocated cost = Cost driver rate × Quantity of cost driver consumed by the product

Example:
– Annual electricity cost (cost pool) = $50,000
– Total labor hours (cost driver) = 2,500
– Cost driver rate = $50,000 ÷ 2,500 = $20 per labor hour
– If Product XYZ uses 10 hours of electricity: allocated overhead = 10 × $20 = $200

Steps to implement ABC

  1. List major activities (e.g., machine setup, quality inspection, order processing).
  2. Create cost pools for these activities and aggregate related overheads.
  3. Choose appropriate cost drivers (transaction counts or duration measures).
  4. Measure total driver volumes and compute driver rates.
  5. Apply driver rates to products, services, or customers to assign costs.
  6. Use results for pricing, product mix decisions, and process improvement.

Cost drivers and activity measures

  • Cost drivers: measures that link resource consumption to activities (e.g., setup hours, machine hours, purchase orders, number of inspections, customer contacts).
  • Two categories of drivers:
  • Transaction drivers: count how often an activity occurs (e.g., number of setups).
  • Duration drivers: measure how long an activity takes (e.g., hours of setup time).

Five activity levels in ABC

  • Unit-level: Per unit produced (e.g., power consumed per item).
  • Batch-level: Per batch, regardless of batch size (e.g., setup for a production run).
  • Product-level: Related to a specific product regardless of volume (e.g., product design).
  • Customer-level: Related to specific customers (e.g., account-specific service).
  • Organization-sustaining: Necessary company-wide activities not tied to products, batches, or customers (e.g., plant security).

Advantages

  • More precise overhead allocation across diverse products and services.
  • Better identification of inefficient or high-cost activities.
  • Improved pricing and profitability analysis for products and customers.
  • Supports targeted cost-reduction and process-improvement initiatives.
  • Reveals when overhead should be shifted from high-volume to low-volume products.

Limitations and practical considerations

  • Data collection and implementation can be time-consuming and costly.
  • Requires management commitment and good measurement systems.
  • Complexity increases with the number of activities and cost pools.
  • Often best used alongside other management accounting tools and targeted to areas where overhead complexity or product diversity makes traditional methods misleading.

Key takeaways

  • ABC links overhead to the activities that generate costs, improving cost accuracy.
  • It relies on cost pools and activity drivers to allocate costs more fairly than volume-based methods.
  • Useful for pricing, product-line profitability, and process optimization, but requires careful design and ongoing data collection.