Activity-Based Costing Definition, Process, & Example

activity based costing

The problem with this approach is that it doesn’t take into account the different activities involved in the manufacturing of different products. Once you determine the rate of allocation, you apply it evenly to all products. Since you incur these costs during the manufacturing of a product, you still need to allocate them. While you cannot directly tie these costs to a certain product, they are still necessary for the operations of the business.

  • IntelligentTech is a software company interested in setting up new pieces of manufacturing equipment throughout their facilities.
  • Activity-based costing is another approach to the allocation of overhead costs.
  • The purchase requisition note is not raised in the purchasing department where most of the costs relating to procurement or purchase are incurred.
  • After arriving at different rates, we now have to arrive at product level total cost.
  • The cost information provided by ABC is generally regarded as more accurate than the information provided by most traditional costing methods.

After you identify and trace the costs, you then assign them to different cost pools. Cost data gathering involves the determination of the costs incurred by the activities being analyzed.

Explanation of Activity-Based Costing:

With ABC, you assign costs to each activity in the production process, giving you a more complete picture of the actual costs. In defining ABC, first of all, what we would say is it is a more complex system of cost accounting than absorption costing.

For companies with a simpler production process, the ABC system could be relatively useless. Having an ABC system can help an organization fully understand the production facility’s overhead costs. This allows professionals to compare the expenses related to production between several different facilities. With this information, they can make informed choices when selecting strategies to help the company save money.

Treating fixed costs as variable

This information is needed to calculate the product cost for each unit of product, which we discuss next. Direct costs – costs that can be easily and conveniently traced to a specific cost object. Direct materials and direct labor are the most common direct costs in manufacturing. Chair one is made from red oak wood and chair two is made from white oak wood. The red oak used in the manufacturing activity based costing of chair one is a direct materials cost incurred for chair one because the red oak wood used is traced only to chair one. Activity-based costing is most helpful in situations with complex production costs. When a company uses machines to manufacture several products, they have several lines of products or there are frequent machine setups, that’s when ABC offers valuable information.

  • An activity is defined as a process, function, task, or step that occurs over time and generates results that the company uses to produce and sell its products and services.
  • In a more competitive environment, companies must be able to assess product profitability realistically.
  • And any time they learn of a significant and permanent shift in the efficiency with which an activity is performed, they update the unit time estimate.
  • This may include higher compensation to attract and retain frontline healthcare workers, or increased staffing levels to extend patients’ face time with providers.
  • Calculate the per unit profit for each product using the plantwide approach and the activity-based costing approach.

Quality programs, continuous improvement efforts, reengineering, or the introduction of new technology can enable the same activity to be done in less time or with fewer resources. When permanent, sustainable improvements in a process have been made, the ABC analyst recalculates the unit time estimates to reflect the process improvements. For example, if the customer service department gets a new database system, the reps may be able to perform a standard credit check in 20 minutes rather than 50 minutes.


Until managers are willing to use the ABC information to make improvements in the organization, there is no point in implementing such a system. Calculate the cost activity rates for each pool identified in #1 using the cost drivers in #2. Cost pools – a “bucket” in which individual indirect costs that are related to a single activity are accumulated. Large, company-wide installations of the activity-based costing system can take several years and a lot of effort.

  • Companies that use activity-based costing may identify hundreds of activities required to make their products.
  • In addition, it can be useful for the controller to monitor the actions taken by management in response to ABC reports.
  • For example, if your company requires higher levels of customer service, you need to handle product returns or you have a cooperative marketing agreement, ABC will help you determine costs and which customers are more profitable.
  • Using this activity-based costing system will give management a more accurate product cost.

The best way to avoid these issues is by developing a highly specific ABC system that focuses on gathering only the most important information. If the system is effective, you can gradually expand it to other areas of the company. Gillian Davenport is a business writer with professional experience in finance and accounting. Hearst Newspapers participates in various affiliate marketing programs, which means we may get paid commissions on editorially chosen products purchased through our links to retailer sites. All products with 50+ points are designated as a Leader in their category. The most valuable feature of Microsoft Dynamics AX is customization.The most valuable features of Microsoft Dynamics AX are field services and the vendor collaboration portal.

Business in Action 3.2

ABC entails the complex task of identifying discrete activities and identifying the measure of output for each of these activities. Each activity also needs to be classified as either ‘value-added’ or ‘non-value-added.’ Value-added activities are activities that add value to the product or service that the customer is willing to pay for. Thus, all steps required to manufacture a product or enhance its quality or reliability are value-added activities. On the other hand, non-value-added activities are activities that do not contribute any value to the final product, and are other activities that the customer doesn’t really want to pay for.

activity based costing

Then you add the total overhead for each cost pool to arrive at the total overhead cost of each product. Now that we have our cost driver rate, we can finally compute the overhead cost of each product. As discussed earlier, value-adding activities contribute something of ‘value’ directly to the manufacture of the products or rendering of the services sold to the customer, while non-value-adding activities do not.

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