What is the purpose of Activity Based Costing?

Activity-based costing is a more accurate method or approach of estimating the cost of a product or
service, resulting in more accurate pricing decisions. It helps managers' understanding of expenses of
the company by knowing the activities to allowing them to be reduced or removed. Activity based
costing allows for a more effective challenge of operating costs in order to find better ways to manage
and eliminate the expenses. It also helps in proper analysis of product and client profit.

When should Activity Based Costing be used?

Activity Based Costing is used to develop a better understanding of costs, helping companies to build a
more effective pricing strategy. Target costing, product costing, product line profitability analysis,
customer profitability analysis, and service pricing all use this costing system.

 Determining a product's or service's pricing

 Processes, goods, activities, or even entire departments that aren't working properly are
detected.
 Achieving cost-control, at the product level or departmental level
 Identification of unneeded costs that can be avoided.
 Determine which products, activities, or departments are profitable and to which more
resources should be given.

What is Activity Based Costing and how does it work?

A strategy to activity costing and monitoring that includes following consumption of resources
and determining total output costs. Based on consumption estimations, resources are assigned
to activities, and activities to cost objects. Cost drivers are being used by the other one to
connect costs to activities to outcomes.
Activity-based costing differs from standard costing approaches in that it assigns expenses to
the activities that are the original source of operating costs. Then after, the costs are assigned
to the products that require those activities.

 Identifying the activities involved in the production process.

 Gathering the costs into pools for each activity
 Identifying a measure, or cost driver, for each activity (these could be different
measures for different activities, e.g. hours, square footage, etc.)
 Calculating the units of the cost driver to be applied to each activity, and thus the rate or
proportion to be applied.
 Calculating the costs of each activity
 Applying those costs to products, based on their usage of those activities.
 Activity Budgeted Cost Cost Driver Cost
Number of
Machine Set-up 200,000 340
Machine-Setups
Inspection 140,000 Inspection Hours 7,500
Using the ABC costing method, both machine-set up costs and inspection costs can be
calculated by dividing cost pool total with cost driver. XYZ company would use the following
formula:
Machine Set-up Costs (200,000/340) = 588.24
Inspection Costs (140,000/7500) = 18.67

Cost Pool- Estimated

Cost Driver Expected Activity
Activity Overhead
Number of
Purchase 120,000 200
purchase orders
Production steps 202,500 Number of set-ups 250
Assembling 80,000 Assembly hours 1600
Machine
300,000 Machine hours 10000
Maintenance
XYZ company would use the following formula from ABC costing:
Overhead rate for purchasing activity (cost pool/cost driver)
120,000/200= 600
Overhead rate for assembling activity (cost pool/cost driver)
80,000/1600= 50
Overhead rate for machine maintenance and overhead rate for production steps would also be
calculated in a similar way.

References: https://www.techjockey.com/blog/activity-based-costing
https://stride.services/blog/when-is-activity-based-costing-needed/
https://www.investopedia.com/terms/a/abc.asp