Introduction and definition of Activity Based Costing (ABC)

Activity based costing (ABC) assigns manufacturing overhead costs to products in a

more accurate way than the traditional costing by just allocating costs on the basis of
machine hours. Activity based costing assigns costs to the activities that are the real cause
of the overhead. It then assigns the cost of those activities only to the products that are
actually demanding the activities. ABC recognizes the relationship between costs,
activities and products, and through this relationship assigns indirect costs to products
accordingly.
There are 5 important steps in ABC. Firstly, we have to identify costly activities or cost
objects. Take hospital as example. Processing patients admission include meeting with
patients, key in patients information to the system and running report with insurance
company for billing. Secondly, we need to assign overhead costs to the activities which
already being identified. For example, cost assigned to process admission includes items
such as wages of staff and depreciation of computer that used to process patients
information. Thirdly, cost driver for each activity needs to be identified. Example is
shown below
Activities Cost Driver
Meeting with patient Hours of meeting time
Key in patients information Number of patients information being key in

After that, we calculate a predetermined overhead rate for each activity. Lastly, we
allocate overhead costs to products.
ABC used to be more popular among the manufacturing sector but now is being used by
service sector as well. Taking healthcare industry as example, ABC allows them to have
more accurate information of the cost of an episode of care, allocation of administrative
costs to products, comparison of costs and their causes over time and information
regarding the cost of various activities