Activity based costing sometimes referred to as ABC, is an alternative approach to the traditional method of allocating overhead costs to products. Traditional costing assumes you can manage costs whereas activity based costing assumes you cannot manage costs but can manage the activities which cause the costs.
Traditional costing allocates overhead to a product using an arbitrary method such as for example, direct labor hours. This method is fine providing the allocated overhead cost is a small proportion of the total cost of the product. However, as technology improved, direct costs reduced, the proportion of overhead increased, and the allocation method often resulted in misleading product costings.
Activity based costing was an attempt to overcome this problem by first analyzing the overhead into activities (such as material handling, purchase order processing) and then allocating the overhead to the product based on how much of that activity the product used.
Activity Based Costing Example
As an example of how to calculate activity based costing, suppose a business has overheads of 300,000 for an accounting period, manufactures a product which takes 2 direct labor hours to produce, and has total direct labor hours used in the period of 500.
The traditional approach would allocate overhead based on direct labor hours as follows:
Allocated overhead = Overhead x Hours used / Total hours Allocated overhead = 300,000 x 2 / 500 = 1,200
Each product would have 1,200 of overhead cost allocated to it.
Now suppose that the overhead can be analysed into two defined activities as follows:
The final column is the ratio of the cost of the activity to the quantity of the activity, and is sometimes referred to as the activity cost rate.
Now, if the manufacture of the product requires 25 material movements and 100 purchase orders, then the activity based costing formula would allocate overhead to the product as follows:
For each activity Allocated overhead = Number of activities x Overhead cost per activity Allocated overhead = 25 x 40.00 + 100 x 10.00 = 2,000
The effect in this simple activity based costing example, is to allocate overhead of 2,000 to the product instead of 1,200 under the traditional approach. The traditional approach, allocating by direct labor hours, distorts the result as the low number of direct labor hours required to manufacture the product has taken no account of the larger material handling and procurement costs required for the product to be manufactured.
Activity Based Costing Terminology
Cost Objects or Outputs
In the above example, the product is the cost object. It is the object which consumes the activity and to which the overhead costs are allocated to by activity based costing. The cost object does not have to be a product, is could be for example, a service, customer, or a market. Cost objects are sometimes referred to as outputs.
In the above example, the activity drivers are the material movements, and the processing of a purchase order for the product. Activity drivers are the events that cause the consumption of the activity by the cost object.
In the above example, the activities are the materials handling, and the procurement using purchase orders.
Resource drivers are used to calculate the cost of each activity. For example, an employee might spend 50% of their time on materials handling and 50% of their time on procurement. In this instance the resource driver is the time spent by the employee on the activity.
A resource is anything available for use by the business. In the above example the resource is the overhead cost.
Advantages and Disadvantages of Activity Based Costing
The benefits of activity based costing are that it is a more accurate method of allocating costs to products, and provides a deeper understanding of the activities which drive the use of resources in a business.
However, the use of activity based costing accounting and establishing an activity based costing system is time consuming and expensive to implement as it requires collection of significant amounts of data; usually necessitating the purchase of activity based costing software.
About the Author
Chartered accountant Michael Brown is the founder and CEO of Double Entry Bookkeeping. He has worked as an accountant and consultant for more than 25 years and has built financial models for all types of industries. He has been the CFO or controller of both small and medium sized companies and has run small businesses of his own. He has been a manager and an auditor with Deloitte, a big 4 accountancy firm, and holds a degree from Loughborough University.