What is activity based costing? – Meaning and suitability

The concepts of Activity-based costing (ABC) were developed in the manufacturing sector of the United States during the 1970s and 1980s. Since then, the practices of overhead cost allocation through the ABC system have gained popularity and have appeared to give more accurate results than traditional costing. In this blog, we make an attempt to understand-what is activity based costing, its features, and where it is suitable. We also throw some light on the advantages of using ABC, and its stages of implementation.

Basics of Activity based costing

Activity based costing is a costing methodology that assigns costs to activities rather than products or services. This allows resources & overhead costs to be more precisely allocated to products and services that consume them. It is a technique that comprises the identification of cost with each cost-driving activity and using it as a basis for apportionment of costs over different cost objects/ jobs/ products/ customers or services.

What is activity-based costing

What is activity based costing?

CIMA defines Activity-based costing as,

Cost attribution to cost units on the basis of the benefit received from indirect activities e.g., ordering, setting up, assuring quality.’

Activity-based costing is a costing method that focuses on activities performed to produce products. It is that costing method in which costs are first attributed to activities and then to products. This costing system is based on the premise that activities are responsible for the incurrence of costs and create the demands for resources. For example, an accounting firm prepares tax returns, a university teaches its students, a restaurant makes food, etc. Costs are charged to products based on an individual product’s use of each activity. In the traditional costing approach, costs are first attributed not to activities but to an organizational unit as a whole, such as a department or a plant, and then to products. This means that under both systems (ABC and traditional absorption costing), the second and final stage consists of tracing costs to the final product.

ABC assigns costs to activities based on their use of resources. It then assigns costs to cost objects, such as products, services, or customers, based on their use of activities. This system can track the flow of activities in an entity by creating a connection between the activity (resource consumption) and the cost object.

The major features of activity-based costing are:

  • Activity based costing is a two-stage product costing process that first assigns costs to activities and then allocates them to products depending upon the level of consumption of activities by each product.
  • An activity is any discrete task that a firm undertakes to offer a product or service.
  • ABC is based on the notion that products consume activities and activities consume resources.
  • The cost of a product equals the sum of costs of all activities required to manufacture and deliver the product. But products do not consume costs directly. Money is spent on activities that are consumed by products/ services.

ABC is particularly needed by entities for accurate product costing in the following situations:

  • Where production overheads are quite high and form a significant portion of costs, ABC is more useful than the traditional costing system as it can determine costs with reasonable accuracy.
  • ABC is suitable especially when there is diversity in the range of products or there are multiple products.
  • Traditional systems are more suitable to allocate volume-related production overheads (e.g., machine-related activities, labor-related activities) based on output, direct labor hours, machine hours, etc. But ABC is a superior and better choice when non-volume related activities (support operations), such as material handling and inspection set-up, are significantly present and conventional systems cannot be used appropriately.
  • When a company is up against a lot of competition and it’s essential to urgently measure costs correctly and set a selling price based on market conditions, ABC proves useful. ABC can also recognize non-value-adding activities in the manufacturing process that might need some focus or could be removed, thereby facilitating cost reduction.

Level of activities under ABC method

Activities comprise units of work or tasks. For instance, the purchase of materials is an activity consisting of a variety of tasks such as purchase requisition, posting an advertisement to invite quotations, identification of suppliers, placement of purchase order, following-up, etc.

Activities basically fall into four distinct categories, known as the manufacturing cost hierarchy. These categories were first defined by Cooper R. in 1990 and help to ascertain the type of activity cost driver required. The categories are:

Activities under ABC system
Type of ActivityExamples
Unit-level activities: These are activities for which the consumption of resources can be identified with the number of units manufactured. It is carried out each time a unit is manufactured.Use of indirect materials/consumables
Batch level activities: The costs of certain activities are driven by the number of batches of units produced. These are activities involved in the setting up of a batch or a production run. They are performed every time a batch is processed.Material ordering, Inspection of products
Product level activities: The costs of some activities are driven by the development of a new product line and its continuing maintenance.Designing the product, Producing parts specifications, and keeping technical drawings of products up to date.
Facility Level Activities: These must be performed regardless of which products are produced. These are activities that are necessary for sustaining the manufacturing process and cannot be directly attributed to individual products.Plant security, Production Manager’s salary, and maintenance of buildings.

Requirements in ABC implementation

A variety of distinct practical stages are required in the implementation of ABC, which are given as below:

  • Staff Training: The co-operation of the workforce is crucial to the successful implementation of ABC. Staff training must be done to raise awareness of the purpose of ABC.
  • Process Specification: Informal, but structured interviews with key members of staff will identify the different phases of the manufacturing process, the commitment of resources to each, processing times, and bottlenecks.
  • Activity Definition: All relevant activities must be defined clearly in the early stage in order to address the issues, if any, effectively.
  • Activity Driver Selection: An appropriate cost driver for each activity shall be selected.
  • Assigning Cost: A single representative activity driver can be used to assign costs from the activity pools to the cost objects.

Limitations of activity-based costing

Activity based costing helps managers in decision-making. However, it has certain limitations too which as are under:

  • Implementing an ABC system requires substantial resources and is more expensive in comparison with the traditional costing system.
  • It is a complex system that needs a lot of records for calculations.
  • It is not much helpful to small organizations. In a small organization, managers are accustomed to using traditional costing systems to run their operations.
  • It may not be applied to entities with limited products.
  • Selection of the most suitable cost driver may not be easy or may be difficult or complicated. Cost drivers are the factors that cause a change in the cost of an activity and act as a basis for apportioning activity costs to products.
  • Reports generated by the ABC system do not conform to generally accepted accounting principles (GAAP). Therefore, an organization involved in activity-based costing needs to have dual cost systems – one for internal use and one for making external reports.

Steps of activity based costing – How to use ABC?

Activity based costing (ABC) is a technique that helps in providing useful information to managers for decision-making. It is a supplemental method of overhead cost allocation that is regarded as superior to the traditional method of cost absorption. Instead of using blanket overhead rates that lack accuracy, ABC links activities to cost objects to ensure a fair determination of product costs. In this section, we guide you through the steps of activity-based costing and how you can implement the same in your costing processes. So, let’s begin!

The terminology of activity-based costing

Before diving into the steps of activity-based costing and how to execute it, it is imperative to know the meaning of terms used in the ABC system. Here is a list of terms:

Activity – An activity refers to an event (of the organization) that incurs cost.

Cost Object – It refers to an item for which cost measurement is needed. It could be a product, a service, or a customer.

Cost Driver – A cost driver is a factor that causes a change in the cost of an activity. Under the ABC system, cost drivers function as the main allocation basis that is used for applying costs to products/ services.

Cost drivers can be categorized into two:

Resource Cost Driver – It gauges the quantity of resources consumed by an activity and is used for assigning the cost of a resource to an activity/ cost pool.

Activity Cost Driver – It gauges the frequency and intensity of demand placed by cost objects on activities. It is used for assigning the cost of an activity to cost objects.

A few examples of cost drivers can be:

FunctionCost Driver
Research and Development1. Number of research projects
2. Personnel hours on a project
3. Technical complexities of projects
Customer Service1. Number of service calls
2. Number of products serviced
3. Hours spent on servicing products
Marketing1. Number of advertisements
2. Number of sales personnel
3. Sales revenue
Design of products, services, and procedures1. Number of products in design
2. Number of parts per product
3. Number of engineering hours
Distribution1. Number of units distributed
2. Number of customers

Cost pool – A cost pool represents a group of various individual cost items or activities. It consists of costs that have the same cause and effect relationship. For example, machine set-up, inspection, ordering, etc.

Steps of activity based costing

Now to follow and implement the ABC system in a business unit, the following steps of activity based costing must be adhered to:

Steps of ABC model

Step 1: Identify resources

First, you should identify the resources that represent the expenditure of your organization. These are the same costs that are represented in traditional accounting; ABC just strives to properly link them to products/ services.

Step 2: Identify different activities

The work done in an organization is represented by activities. The costs accounted for by ABC are dependent on the events that caused them to occur. It is then possible to better relate these costs to consumers, goods, and facilities by assessing the actual activities that occur in different departments.

A conventional overhead system typically uses a limited number of cost centres, say up to fifteen. But the number of activities in ABC will be much higher, say 200; the exact number, though, will depend on how the organization’s activities are subdivided by management.

Some activities may be listed as follows:

  • Production schedule changes
  • Customer liaison
  • Purchasing
  • Production process set up
  • Quality control
  • Material handling
  • Maintenance

Step 3: Identify cost objects

Next, identify the cost objects for which cost ascertainment is required. This is an important step in successful ABC implementation.

Step 4: Determine resource drivers and relate the overheads to activities

Attribute overheads (both secondary and primary) to the activities that caused them. ‘Cost pools’ or ‘cost buckets’ are created as a result of this. This can be accomplished by employing resource cost drivers. Resource drivers build a link between the expenditure of an organization and the activities performed, based on the quantity of resources consumed by a particular activity.

Step 5: Determine cost (activity) drivers and compute activity cost driver rates for each activity

Determining activity cost drivers completes the last stage of the ABC model. Cost drivers trace the costs of performing specific activities to cost objects.

For each activity, determine a cost driver and compute its rate as:

This is based on the factor that drives the consumption of the activity. The question to ask is – what causes the activity to incur costs? In production scheduling, for example, the driver will probably be the number of batches ordered.

Step 6: Assign costs to cost objects

For assigning costs to cost objects, the following formula can be used:

Costs = Quantum of Activities Consumed × Activity Cost Driver Rate

The activity cost driver rates will be multiplied by the different amounts of each activity that an individual product/cost object consumes.

Using this formula, the overheads collected in the activities/ cost pools are then related to the cost objects or products.

Cost allocation under ABC

Example of activity-based costing

Let us take a small case study to understand the working and implementation process of the ABC system.

An Indian Company produces two products: a mobile accessory and back covers. It employs a normal cost system and overheads are currently allocated using a plant-wide overhead rate based on direct labor hours. However, on knowing the benefits of the ABC system, its cost consultants are contemplating the use of activity-based costing to charge overhead costs to products.

In the financial year 2021, the company expects to produce 4,000 mobile accessories and 2,000 back covers. Each mobile accessory requires 2 direct labor hours to produce while each back cover requires 0.5 hours. The direct material and direct labor costs included in the two products are:

Direct costsMobile accessoryBack cover
Direct Material (per unit) in INR3017
Direct labor cost per unit in INR164

Budgeted (or estimated) total factory overheads for 2021:

ActivityBudgeted Overhead in INREstimated Volume Level
Production Setups80,00020 setups
Material Handling70,0005,000 lbs.
Packaging and Shipping1,20,0006,000 boxes
Total Factory Overheads2,70,000 

Based on an analysis of the three overhead activities, it was estimated that the two products would require these activities as follows in 2021:

ActivityMobile accessoryBack coverTotal
Production Setups51520
Material Handling (lbs.)1,0004,0005,000
Packaging and Shipping (boxes)4,0002,0006,000

When the company calculates the cost of each product using a plant-wide rate based on direct labor hours, it gets the below results:

Step 1: Calculation of plant-wide overhead rate:

Total budgeted direct labor hours = 4,000 mobile accessories x 2 labour hours per part + 2,000 back covers x 0.5 labour hour per phone = 9,000 hours

Overhead Rate = Total Budgeted Overhead Cost/ Total Budgeted Direct Labor Hours = Rs. 2,70,000/ 9,000 hours = Rs. 30 per hour

Step 2: Calculation of each product’s cost using a plant-wide rate:

ProductMobile accessoryBack cover
Direct Material (per unit) in INR3017
Direct labor cost per unit in INR164
Manufacturing overhead @ Rs. 30 per labour hour30 x 2 = 6030 x 0.5 = 15
Total10636

Now, the cost of the two products using an activity-based costing system would be computed in the following steps:

Step 1: The Activity Cost Rates for (1) Setups, (2) Material Handling, and (3) Packaging and Shipping

ActivityBudgeted Overhead in INREstimated Volume LevelActivity cost rates
Production Setups80,00020 setups4,000 per setup
Material Handling (lbs.)70,0005,000 lbs.14 per lbs.
Packaging and Shipping (boxes)1,20,0006,000 boxes20 per box

Step 2: Cost of the Two Products Using an Activity-Based Costing System:

ProductMobile accessoryBack cover
No of items produced4,0002,000
Direct Material in INR= 4,000 x 30 = 1,20,000= 2,000 x 17 = 34,000
Direct labour cost in INR= 4,000 x 16 = 64,000= 2,000 x 4 = 8,000
Production set up cost in INR= 5 x 4,000 = 20,000= 15 x 4,000 = 60,000
Material handling cost in INR= 14 x 1,000 = 14,000= 14 x 4,000 = 56,000
Packaging and shipping in INR= 20 x 4,000 = 80,000= 20 x 2,000 = 40,000
Total manufacturing cost for all unitsRs. 2,98,000Rs. 1,98,000
Total units produced4,000 accessories2,000 covers
Total cost per unit74.599

As we see here, the results under ABC differ from that of the traditional costing system. By taking into consideration the actual consumption of different activities (or cost pools) in product costing, ABC tends to estimate results more accurately.

Advantages of activity-based costing – Why is ABC important?

False cost analysis leads to wrong decision-making. Where a business has very few products, conventional cost accounting can be used appropriately, but as companies broaden their product-offering and these products use varying quantities of resources, it becomes difficult to calculate the correct cost of products by using traditional absorption costing and in such cases, it is inevitable to use Activity based costing (ABC).

Activity-based cost-management systems trace indirect and support expenses accurately to individual products, services, and customers. Similar to conventional cost systems, ABC systems use a basic two-stage approach. However, it uses activities instead of using cost centres for cost accumulation.

Activity based costing is a new approach that seeks to rectify the inaccurate cost information. In this blog, we help you understand the practical uses and advantages of Activity-based costing.

Why is it needed?

As global competition intensifies, an increasing range of products and services are being produced by businesses. They find that the manufacturing of different products and services places varying demands on their resources. The need to measure more precisely how different products and services use resources has led companies such as American Express, Boeing, General Motors, and Exxon Mobil to refine their costing mechanisms. One of the main ways through which companies around the globe have refined their costing mechanisms is through activity-based costing.

The goal of ABC is to define as many costs as possible that can subsequently be accounted for as direct costs of production. Under the ABC system, the direct cost of the product becomes any cost that is traced to a particular product via its consumption of activity.

For example, under the traditional costing system, set-up costs and adjustment time are known to be factory overheads and are subsequently allocated to different products on the basis of direct labour hours. In ABC, however, set-up and adjustment time is assessed separately for each product and its costs are directly charged to each product. ABC is usually adopted as a tool for understanding product cost and profitability.

Advantages of activity-based costing

Objectives of ABC

The objectives of Activity based costing are as under:

  1. To improve overall product costing
  2. To identify and locate non-value adding activities in the production process of a business that might be a suitable focus for attention or elimination
  3. To provide useful and required information for decision making
  4. To reduce the frivolous (non-essential) use of common resources
  5. To encourage business managers to evaluate the efficiency of internally provided services
  6. To compute the full cost of products for financial reporting purposes and for determining cost-based prices.

Importance of Activity-based costing

ABC offers information on product costs and product-line profitability for the purpose of decision-making. ABC implementation emphasizes on more effective profit analysis, more realistic costing, better overhead allocation, improved cost control, and better cost management.

One of the main advantages of activity based costing is that it supports managers in making operating decisions such as performance measurement, product design, and process improvement. It is also used to advocate for strategic decisions such as customer profitability and pricing & product mix. Due to the increasing precision of output costs, ABC information facilitates managers to make better decisions on product, product design, process improvement, market segments, and customer mix.

We can, therefore, summarize the importance and advantages of activity based costing as under:

  1. ABC links the cost to its causal factor, i.e., the cost driver.
  2. It gives an easy way to allocate overhead in the product cost.
  3. It helps to identify costs of activities rather than cost centres.
  4. It ascertains product costs with a greater level of accuracy by relating overheads to activities and by eliminating arbitrary cost allocations.
  5. It aims to overcome the inherent limitations of the traditional costing system and the use of blanket overhead rates.
  6. It helps managers in budgeting and performance measurement.
  7. It helps to establish links between activities, organizational acts, and the resources consumed. This also aids in illustrating the differences between resource consumption and resource provision.
  8. ABC seeks to assist in cost control, cost reduction, as well as improved overall profitability.
  9. ABC enhances the quality of information available for decision-making by answering questions such as what activities and events are driving cost and where efforts should be made to control cost.
  10. It renders valuable economic information to support an entity’s operational improvement and customer satisfaction programs.
  11. ABC translates cost into a language that common people can understand easily and that can be linked to business activities.
  12. When compared with traditional absorption costing, ABC furnishes many significant benefits such as:
    • most accurate information about product costs
    • more detailed and extensive cost data for performance measurement
    • relevant data for management’s decision-making
    • more potential for sensitivity analysis
    • providing a model prospect on value-adding transactions and activities of an organization

Uses of Activity-based costing

Some of the areas in which ABC information is used for decision-making purposes are:

  • Activity costs: ABC is designed to monitor the cost of activities, so we can use it to see if the cost of an activity is in line with industry levels. If not, as management focuses on cost control, ABC is an excellent feedback tool for determining the ongoing cost of specific services.
  • Customer profitability: While most of the costs incurred are simply product costs for individual customers, there is also an overhead aspect, such as exceptionally high levels of customer support, product return handling, and cooperative marketing agreements. An ABC system can sort through these additional overhead costs and assess which customers are actually providing a fair profit. Such analysis would result in some unprofitable customers being turned away, or more emphasis being placed on those customers who are contributing more towards profits.
  • Distribution cost: A company uses a number of distribution channels such as retail, internet, distributors, and mail-order catalogs, to market its goods. Part of the structural cost of operating a distribution channel is overhead, so if we can make a fair assessment of which distribution channels are using more overhead, we can make decisions to adjust or even drop unprofitable distribution channels.
  • Make or buy: ABC helps the manager to determine if he can conduct the operation within the organization or outsource it. If the business incurs higher overhead costs relative to the outsourcer, outsourcing may be done or vice versa.
  • Margins: We may calculate the margins of several products, product lines, and entire subsidiaries with accurate overhead allocation from an ABC system. This can be very beneficial in deciding where the capital of the company should be placed to gain the highest margins.
  • Production facility cost: At the plant-wide level, it is usually quite easy to segregate overhead costs, so we can compare the production costs between different facilities.

Takeaway

Activity-based costing deals with the collection of financial and operational information tracing the significant activities of a firm to product costs.

As a more precise cost management tool than conventional cost accounting, ABC recognizes opportunities to increase business process efficiency and effectiveness by assessing the “true” cost of a product or service.

Hope the information provided in this blog proves helpful to you!

To learn more about how ABC offers better results than the conventional system of cost allocation, you may want to read the below blog:

Difference between traditional costing and activity-based costing – Which is better?

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