ACTIVITY-BASED COSTING (ABC)

What Is Activity-Based Costing (ABC)?

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to
related products and services. This accounting method of costing recognizes the relationship
between costs, overhead activities, and manufactured products, assigning indirect costs to products
less arbitrarily than traditional costing methods. However, some indirect costs, such as
management and office staff salaries, are difficult to assign to a product.
How Activity-Based Costing (ABC) Works
Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the
reliability of cost data, hence producing nearly true costs and better classifying the costs incurred
by the company during its production process.
This costing system is used in target costing, product costing, product line profitability analysis,
customer profitability analysis, and service pricing. Activity-based costing is used to get a better
grasp on costs, allowing companies to form a more appropriate pricing strategy.
The formula for activity-based costing is the cost pool total divided by cost driver, which yields
the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount
of overhead and indirect costs related to a particular activity.

The ABC calculation is as follows:

1. Identify all the activities required to create the product.

2. Divide the activities into cost pools, which includes all the individual costs related to an
activity—such as manufacturing. Calculate the total overhead of each cost pool.
3. Assign each cost pool activity cost drivers, such as hours or units.
4. Calculate the cost driver rate by dividing the total overhead in each cost pool by the total
cost drivers.
5. Divide the total overhead of each cost pool by the total cost drivers to get the cost driver
rate.
6. Multiply the cost driver rate by the number of cost drivers.

As an activity-based costing example, consider Company ABC that has a P50,000 per year
electricity bill. The number of labor hours has a direct impact on the electric bill. For the year,
there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost
driver rate is done by dividing the P50,000 a year electric bill by the 2,500 hours, yielding a cost
driver rate of P20. For Product XYZ, the company uses electricity for 10 hours. The overhead
costs for the product are P200, or P20 times 10.
Requirements for Activity-Based Costing (ABC)

The ABC system of cost accounting is based on activities, which are any events, units of work, or
tasks with a specific goal, such as setting up machines for production, designing products,
distributing finished goods, or operating machines. Activities consume overhead resources and are
considered cost objects.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost
driver. A cost driver, also known as an activity driver, is used to refer to an allocation base.
Examples of cost drivers include machine setups, maintenance requests, consumed power,
purchase orders, quality inspections, or production orders.

There are two categories of activity measures: transaction drivers, which involves counting how
many times an activity occurs, and duration drivers, which measure how long an activity takes to
complete.
Unlike traditional cost measurement systems that depend on volume count, such as machine hours
and/or direct labor hours to allocate indirect or overhead costs to products, the ABC system
classifies five broad levels of activity that are, to a certain extent, unrelated to how many units are
produced. These levels include batch-level activity, unit-level activity, customer-level activity,
organization-sustaining activity, and product-level activity.

Benefits of Activity-Based Costing (ABC)

Activity-based costing (ABC) enhances the costing process in three ways. First, it expands the
number of cost pools that can be used to assemble overhead costs. Instead of accumulating all
costs in one company-wide pool, it pools costs by activity.

Second, it creates new bases for assigning overhead costs to items such that costs are allocated
based on the activities that generate costs instead of on volume measures, such as machine hours
or direct labor costs.

Finally, ABC alters the nature of several indirect costs, making costs previously considered
indirect—such as depreciation, utilities, or salaries—traceable to certain activities. Alternatively,
ABC transfers overhead costs from high-volume products to low-volume products, raising the unit
cost of low-volume products.

KEY NOTES

 Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such

as salaries and utilities—to products and services.
 The ABC system of cost accounting is based on activities, which are considered any event,
unit of work, or task with a specific goal.
 An activity is a cost driver, such as purchase orders or machine setups.
 The cost driver rate, which is the cost pool total divided by cost driver, is used to calculate
the amount of overhead and indirect costs related to a particular activity.
ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing
strategy.

Traditional Costing method

In a traditional costing method, we calculate one plantwide allocation rate or we could calculate
an overhead allocation rate for each department. We have a three step process:

Step 1: Determine the basis for allocating overhead or indirect costs. These can be anything a
company decides but most common are direct labor cost, direct labor hours, direct material usage
or machine hours.

Step 2: Calculated a predetermined overhead rate using estimates. This is typically calculated at
the end of the year to be used during the following year. The formula we use for this is:

Estimated Overhead
Predetermined Overhead Rate (POHR) =
Estimated Base (or cost driver)

Step 3: Apply overhead throughout the period using the actual amount of our base and the
predetermined overhead rate (POHR) calculated in step 2. We calculate this as:

Applied Overhead = Actual amount of base x POHR

Example:

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.

High Challenge Company allocated manufacturing overhead costs to the two products for the
month of January. Department A had estimated overhead of P2,000,000 and used 20,000 machine
hours. High Challenge has decided to allocate overhead on the basis of machine hours.

At the end of January, High Challenge had used 1,500 machine hours for the Touring bicycle
product line and 500 machine hours for the Mountain bicycle product line.
A. Calculate the predetermined overhead rate
B. Allocate the overhead to each product

Methods used for activity-based costing

Activity-based costing requires accountants to use the following four steps:

1. Identify the activities that consume resources and assign costs to those activities. Purchasing
materials would be an activity, for example.
2. Identify the cost drivers associated with each activity. A cost driver is an activity or
transaction that causes costs to be incurred. For the purchasing materials activity, the cost
drivers could be the number of orders placed or the number of items ordered. Each activity
could have multiple cost drivers.
Cost driver Cost of assigned cost driver
Miles driven Automobile costs
Machine-hours Electricity to run machines
Customers served Overhead in a bank
Flight hours Airplane maintenance costs
Number of
Selling costs
customers

3. Compute a cost rate per cost driver unit. The cost driver rate could be the cost per purchase
order, for example.

Predetermined Overhead Rate (POHR) = Estimated Overhead

Estimated Base (or cost driver)

4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver
units consumed by the product. For example, the cost per purchase order times the number
of orders required for Product A for the month of December would measure the cost of the
purchasing activity for Product A for December.
We first define the notion of an activity center. An activity center is a unit of the
organization that performs some activity. For example, the costs of setting up machines
would be assigned to the activity center that sets up machines. This means that each activity
has associated costs. When the cost driver is the number of inspections, for example, the
company must keep track of the cost of inspections.
 Workers and machines perform activities on each product as it is produced. Accountants
allocate costs to products by multiplying each activity’s indirect cost rate by the volume of
activity used in making the product. The formula we will use for each activity is:

Applied Overhead = Actual amount of activity cost driver x activity POHR

Example:

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.

In using activity-based costing, the company identified four activities that were important cost
drivers and a cost driver used to allocate overhead. These activities were (1) purchasing materials,
(2) setting up machines when a new product was started, (3) inspecting products, and (4) operating
machines.

Accountants estimated the overhead and the volume of events for each activity. For example,
management estimated the company would purchase 100,000 pieces of materials that would
require overhead costs of P200,000 for the year. These overhead costs included salaries of people
to purchase, inspect, and store materials. Setting up machines for a new product would need 400
setups and overhead of P800,000. The company would have 4,000 inspections and overhead of
P400,000. Finally, running machines would cost P600,000 for 20,000 machine hours.

These estimates were made last year and will be used during all of the current year. In practice,
companies most frequently set rates for the entire year, although some set rates for shorter periods,
such as a quarter.

Allocate the total overhead cost using Activity-Based Costing.