What is activity-based costing (ABC) and how does it work?

Team Nomi

Sep 16, 2020
6 minutes read

What is Activity-based costing (ABC)?

Activity-based costing (ABC) is defined as a technique for allocating costs to acquisitions, tasks, service projects, and products, based on:

• Resources used up by such activities.
• The events that go into them.

ABC is very different from traditional costing, better referred to as cost accounting, which occasionally allocates costs using an arbitrary apportionment percentage for overheads – also referred to as indirect costs.

As an outcome, traditional cost accounting and activity-based costing can forecast the price of goods traded and gross margin in a very different way for individual items or units. Inconsistent and ambiguous cost estimations can be problematic for a company’s management as the management is keen on knowing the exact profit of a product, along with the products which are loss-making.

ABC is an accounting system that classifies and allocates costs to overhead undertakings and then allocates those costs to products. This system identifies the association between manufactured products, overhead activities, and costs.Through this association it allocates indirect costs to goods less arbitrarily than cost accounting. However, it might be tough to allocate certain costs, such as office staff and management salaries, through this method. Because of this challenge, the ABC system has found its position in the manufacturing sector.

ABC is usually adopted in manufacturing as it augments the consistency of cost data, therefore closely monitoring costs and leading to improved categorisation of costs experienced by an organisation during its fabrication process. This costing system is adopted in customer profitability analysis, product line profitability analysis, product costing, service pricing, and target costing. It is also immensely popular, since organisations can cultivate a much-improved corporate strategy and focus if prices are better computed.

Definition of activities in the ABC system

The ABC system is built on events; which is any occurrence, portion of work, or job with a precise goal such as establishing machines for fabrication, distributing finished goods, designing products, or operating machines. Activities include overhead resources and are measured cost objects. According to the ABC structure, an activity can also be measured as any contract or incident that is an activity (cost) driver – an activity driver is used to denote an allocation basis. Examples of activity drivers include power consumption, production orders, maintenance requests, machine setups, or quality inspections. There are two classes of activity measures: transaction drivers, which includes the number of times an activity has occurred; and duration drivers, which measure the timeperiod taken to complete an activity.

On the other hand, the traditional cost account system relies on volume count, such as direct labour hours or machine hours, to apportion indirect or overhead costs to goods. The ABC system categorises the activities into five all-encompassing levels of activity that are not linked to the number of units produced. Levels include:

• Batch-level activity.
• Customer-level activity.
• Product-level activity.
• Organisation-sustaining activity.
• Unit-level activity.

Activity-based costing has expanded its footprint in recent decades because:

• Manufacturing overhead charges have become greater than before.
• Manufacturing overhead charges no longer associate with the direct labour hours or productive machine hours.
• The diversity of customer demands and products have expanded.
• Certain products are manufactured in large lots, while others are manufactured in small lots.

How the ABC system improves the costing process?

Activity-based costing augments the costing process in three ways. Firstly, it increases the number of cost groups that can be considered to draw together overhead costs. As an alternative of amassing all costs in one organisation-wide group, it groups costs by activities. It also generates new bases for allocating overhead costs to products. As such, costs are assigned based on the events that create costs instead of on capacity measures, such as direct labour costs or machine hours.

Lastly, ABC modifies the nature of numerous indirect costs, making costs formerly considered indirect – such as inspection or depreciation – traceable to specific activities. On the other hand, ABC allocates overhead costs from high-volume goods to low-volume goods, increasing the unit cost of low-volume goods.

Activity-based costing (ABC) process flow

Activity-based costing can be explained through various steps such as:

Identifying costs: The first step in ABC is to categorise those costs that need to be allocated; this is the most important step in the whole process. For instance, if a business aims to define the entire cost of a distribution channel, it should take into account warehousing and advertising costs, and cost pertaining to research and other products.

Create the primary cost group: It is advisable to segregate costs for each product line. Also, if production lots are of varying length, it is advisable to consider allocating cost for each batch level.

Create a secondary cost group: Identify secondary costs incurred to offer services to other business functions; secondary cost groups characteristically comprise of administrative salaries, computer services etc. Later, these are allocated to other cost pools that are in a straight line with products and services.

Evaluate activity or cost drivers: A business can use a data management system to gather information about the cost drivers that are used to apportion the costs.

Cost Objects: To distribute the costs, divide the entire cost in each cost group by the entire amount of activity in the activity or cost driver.

Formulate Reports: Translate the outcomes of the ABC system into information for management consumption.

Uses of Activity-based costing (ABC)

• ABC provides a more precise cost per unit. As a result, decisionmaking, performance management, pricing, and sales strategy should improve.
• ABC offers much better understanding of what pushes up overhead costs.
• ABC identifies that overhead costs are not all associated to sales volume and goods produced.
• In numerous companies, overhead costs are a noteworthy percentage of total costs. Overhead costs can be measured by handling cost drivers.
• The ABC system can be used for all overhead costs, not just manufacturing overheads.
• ABC can be applied to establishaccurate costs in a multi-faceted business environment.
• ABC can be used easily in service costing.

Problems with Activity-based costing (ABC)

• ABC will not be of much use if the overhead charges are volume-driven, or if the overhead is a minor percentage of the total cost.
• It is difficult to assign all overhead charges to explicit activities.
• The choice of both cost drivers and activities might be unsuitable.
• It can be difficult to explain to stakeholders the ABC computation process.
• The advantage achieved from ABC might not explain the costs.
• Other structures may need to be altered – for instance, how variance is computed.

Computing cost per unit using Activity-based costing (ABC)

• Group production overheads into activities. For each cost or activity group, there must be a cost driver.
• Identify cost drivers for each activity.
• Compute the overhead absorption rate (OAR) for each cost or activity.
• Absorb the activity costs into products.
• Compute the complete production cost for each unit, along with profit or loss.