Activity-Based Costing Definition, Process, & Example

The good news is software like Smartsheet (here’s our Smartsheet review) can help you do the calculations thanks to powerful spreadsheets. Thus, the activity based system system uses activities instead of functional departments (Cost Centers) for absorbing overheads. Assume High Challenge Company makes two
products, touring bicycles and mountain bicycles.

  • (i) All activities in the factory which create costs are identified.
  • ABC implementation might face resistance from consultants accustomed to traditional billing methods.
  • It should be noted that directs costs do not need cost drivers as they can be identified directly to a product.
  • 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.
  • This method offers a more accurate reflection of how resources are utilized, attributing costs directly to the activities that drive them.

Activity-based costing helps you identify where you’re wasting money. If you find that some activities cost more than they should, you can find new methods to do something. In the table below, we present several examples of the cost drivers companies use. Most cost drivers are related to either the volume of production or to the complexity of the production or marketing process. Activity cost centres are, sometimes, similar to cost centres used under traditional costing system. In case the purchase department and purchasing activity both are treated as cost centres, the support activity cost centre also becomes identical to cost centre taken under traditional costing system.

Generally, the products are cost objects, but the customers, services or locations can also be the cost objects. A hospital employing ABC identifies activities like patient admissions, diagnostics, and specialized care. By attributing costs to these activities, the hospital realizes that certain specialized services, though essential, consume more resources than general treatments. This knowledge empowers the hospital to refine pricing strategies or explore resource reallocation to maintain quality care while managing costs. Unit level activities are activities that are performed on each unit of product.

Circumstances in which Activity Based Costing is Suitable for Product Costing

Traditional costing is simpler but less specific than activity-based costing. You might consider going with traditional costing if you only make a few products. This is different to traditional time-driven activity-based costing, which assigns a more generalised percentage of these costs to a broader production measurable, like a run of a product or financial quarter. The different calculations often give very different gross margin and cost of goods sold figures. This formula applies to all indirect costs, whether manufacturing overhead, administrative costs, distribution costs, selling costs, or any other indirect cost. That means, overhead expenses are initially identified with the cost centres (i.e., departments, divisions, branches, etc.) and then, they are identified with, and charged to, the products.

The quantity measure of the resources used/consumed by an activity is called Resource Cost Driver. It is used to assign the cost of a resource to an activity or cost pool. Activity costs tend to behave in a similar manner to each other i.e., they have the same cost driver or the factor causing a change in the cost of an activity. Notice how the total overhead for the month of
January is the same at $200,000 but the amount allocated to each
product is different. Step 1 is often the most interesting and
challenging part of the exercise.

  • Next, you calculated the total cost that goes into each activity, identified the cost driver that is most relevant to each activity and calculated the activity rate.
  • They identify various activities like stocking, customer service, and checkout processes.
  • Let’s take a look at three examples to give you more insight into the costing system.
  • ABC helps managers to identify and control the cost of unused capacity.

The next step is to allocate each cost pool to the product by using cost drivers. We have to understand how each product consume the cost, so that we can allocate each cost driver to individual product. You must run through this process for each cost pool and your cost drivers. Once you have done this, you will better understand the costs to manufacture your product, which will help you price your product correctly. To do this, you divide the total overhead of each cost pool by the total of your cost drivers.

Break Down Where Your Money Goes With Activity-based Costing

Where selling prices are fixed on the basis of cost plus formula, ABC provides more reliable data for fixing selling prices. ABC has also enabled enterprises to model the impact of cost reduction and subsequently confirm the savings achieved. With ABC, any enterprise will have a built-in competitive cost advantage and can continuously add value to both its stakeholders and customers.

Benefits and drawbacks of activity-based costing

It may be noted here that the prime costs are identified with, and charged directly to, the products. Transaction drivers include number of transaction which results in overhead costs e.g., inspections performed, setups undertaken, number of purchase orders etc. CIMA defines ABC as, “Cost attribution to cost units on the basis of benefit received from indirect activities”.

Managing deliveries and drivers?

Or imagine the activities involved in making a complex product such as an automobile or computer. Assume High Challenge Company makes two products, touring bicycles and mountain bicycles. The touring bicycles product line is a high-volume line, while the mountain bicycle is a low-volume, specialized product. ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. Management of overhead cost is achieved by coupling the costs to the activities that ‘drive’ or ’cause’ them. With ABC, enterprises are able to improve their efficiency and reduce costs without sacrificing the value for the customer.

Activity Based Costing – Evolution of ABC

This may encourage managers to adopt a holistic view of the organization. However dealing with him may lead to open up new markets and thus be profitable for the business as a whole. It is a system to improve strategic and operational decisions in an organization.

Activity Based Costing – Top 7 Objectives

It can also be defined as “the collection of financial and operational performance information tracing the significant activities of the firm to product costs”. In order to overcome the problems faced in traditional approach of overhead distribution, a new and more scientific approach was developed by Cooper and Kalpan known as Activity based costing. The ABC aims to identify the activities which results in currency of the cost. The main focus is on activities performed on a particular product during its production. Activities can be defined as a named pro­cess, function, or task that occurs over time and has recognized results.


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