Limited Time Offer 70% Off for 3 Months Buy Now & Save

You're currently on our UK site. Select your regional site here: Select your region ×
CALL SALES +44 (0)800 047 8164 CONTACT US LOGIN
Features Who It’s For Resources Pricing
TRY IT FREE

9 Min. Read
All Articles

Accounting Activity-Based Costing (ABC):

Taxes Definition, Example & Process
Hub > Accounting
Startup
September 2, 2021
Estimates

Productivity

Expenses
This site uses cookies. By continuing to browse the site you are agreeing to our use of cookies. Review our cookies
AGREE DISAGREE
information
Other for more details.

Leadership

Reports

Invoicing

Payments

Marketing

Insurance Accurate pricing of goods and services is one of the most difficult things business
owners need to tackle. Each product or service needs the ‘just right’ price. One that’s
Projects Management going to attract customers because it realistically reflects value and isn’t overpriced.
While simultaneously making you a good profit margin.
Finance
This isn’t easy.

You have to take so many different factors into account; where you sit in the market,
what your competitors are doing and maximising profit margin without deterring
customers - to name but a few.

Another tricky element is accounting for all those indirect costs and overheads, like
utilities and staff. Some companies decide to use Activity-Based Costing to include a
truer picture of where this type of spending is really going. It’s a proportional look at
how much of these operational costs are attributable to each product or service, as
well as their direct costs of production.

This type of accounting formula is mostly used in manufacturing industries, where it’s
easier to assign precise production costs to each product. And you need to judge if it’s
right for your business. Will it help you with your pricing strategy or not?

Let’s find out…

Here’s What We’ll Cover:

Definition of Activity-Based Costing

Step-by-Step Process for the Activity-Based Costing Method

Example of Activity-Based Costing

Benefits of Using Activity-Based Costing

Disadvantages of Using Activity-Based Costing

Should I Use Activity-Based Costing?

Definition of Activity-Based Costing

Activity-Based Costing is a method of assigning indirect and overhead costs to each
of your products or services - giving you a better idea of their actual costs.

This is different to traditional time-driven activity-based costing, which assigns a

more generalised percentage of these costs to a broader production measurable, like
a run of a product or financial quarter. Here’s a more detailed look at the alternative
costing formulas. The different calculations often give very different gross margin and
cost of goods sold figures.

Back to Activity-Based Costing (ABC). Let’s define all the individual terms you need to
understand the ABC accounting method.

Overheads and indirect costs: admin, finance, distribution, utilities

Activities – things that must be done to produce the product. This can be a job,
event or set of work that has a specific objective and consumes resources.

Activity Cost Pool – aggregate of all the fixed and variable individual costs
connected to a business task. Categorisation of the different activities. E.g.:
Machine set-up, maintenance, purchase-ordering, invoicing. Work out the
overheads that apply to each cost pool.

Cost driver – activities that drive, or cause, costs. If this doesn’t happen, then cost
isn’t incurred. Also, the measuring device.

Cost driver rate – A calculation: cost pool total / cost driver. This tells you the
amount of indirect and overhead costs that relate to that particular activity.

Examples of an Activity Cost Pool and Related

Examples of Cost Drivers
Administration of purchase-orders to suppliers: number of orders sent

Machine set up: number of machine setups needed

Order processing: number of invoices sent

Customer Service: number of customers given assistance

Health and Safety Inspections: number of inspections completed

Remember that one cost pool can have more than one cost driver.

A useful broad perspective on this is - activities consume resources (and might be

called 'cost objects’ by your accountant); products, customers and manufacturing
channels consume activities.

For each product, you’re working out how much its activity consumption costs.

Step-by-Step Process for the Activity-

Based Costing Method
You want to action the ABC formula:

(Overhead for cost pool / cost drivers) X Amount of Activity Cost Driver

Here’s how, in 6 steps.

. List all the activities that you need to spend money on to create your product.
. Group these activities into cost pools, like the examples above
. Work out the total overhead for each cost pool
. Decide which cost drivers apply to each cost pool (eg hours, number of items
processed)
. Divide the total overhead for each cost pool by the appropriate cost driver(s),
this is your cost driver rate.
. Multiply the number of activity cost drivers by this cost driver rate to get the
overhead cost for a particular product.

Example of Activity-Based Costing

For example, you’ve set up 5,000 machines, with an overhead of £11,000.

Overhead = £11,000

Cost driver = 5,000

Cost driver rate = cost pool overhead / cost driver

Your cost driver rate = 11,000 / 5,000 = 2.2

300 of these new machines are for your new product, and you want to factor this into
working out the overall cost of production to predict if it will be profitable.

Overhead costs for new product = Activity cost drivers X cost driver rate

OVerhead costs for new product = 300 X 2.2 = 660

Overhead costs for new product = £660

Benefits of Using Activity-Based

Costing
The overarching benefit to this costing method is to get a clearer and more detailed
financial picture of your production costs. When you dig into it, you can use this to
improve your business in several ways.

Overhead Costs
This method shows you exactly where all overhead costs are being spent and what is
causing them. As a business owner, you have the opportunity to analyse all of these
specific costs and their drivers to see if efficiencies can be made.

Perhaps the ABC approach will flag up some interesting information about your
overheads and lead to questions like: ‘Why is our electricity bill so high?’ Maybe your
offices are poorly insulated and the heating costs soar in the winter months. The
conversation then becomes about which is better for your business – move to a more
energy efficient building, or invest in better insulation.

Quite the journey from applying one accounting method to your product costs. But
one that can save you a lot of money over time. And on an issue that otherwise might
never come into the forefront.

Business Budgeting
You now have a precise idea of your costs, which obviously leads to a more exact
budget and clearer business planning. You can see where your money is being spent
and which products are going to make you the most profit. You can compare the true
cost of making different products, see if they’re bringing in enough profit and take
action accordingly.

Process improvement
Many companies discover process improvements that can be made after analysing
their ABC figures. Most shop floor procedures can be redesigned to increase
efficiency or reduce costs.

For example, the cost of individual customers can be calculated by using the ABC
method. Not just product costs, but the indirect costs of processing returns,
marketing agreements and high customer service requirements. Just by automating
part of the returns process could hugely improve this process and reduce the
associated overheads.

Pricing
Back to where we started, with the never-ending balancing act of pricing your
products. With ABC, you get your product cost analysis – crucially – including the
indirect and overhead costs that other strategies don’t encompass. This may mean
that you need to increase your prices in order to maintain an acceptable profit margin.

Disadvantages of Using Activity-Based

Costing
Complexity
Compared to traditional costing methods, the ABC system of cost accounting is
much more complicated. No more general overhead costs and activities – you have to
be specific.

How many staff hours are spent on that product’s order forms?

What proportion of the electricity bill is needed to power that activity?

You need a member of staff with the knowledge and time to collect and collate this
amount of data. And to make it sustainable and repeatable, you need to implement an
efficient system throughout your company. Many SMEs find that the cost of putting
this in place outweighs the ROI of this accounting system. And that’s even FreshBooks
clients that have all the cost information they need right there, a couple of clicks away.

Accuracy
And ABC, although complex, can’t be 100% accurate. No method of costing comes
with a 100% guarantee. They’re usually based on at least some partly-estimated
figures. For example, apportioning utilities costs to particular activities is an educated
guess, not a ‘to the penny’ calculation.

Should I Use Activity-Based Costing?

You need to consider the best accounting method of costing for your business.
Remember, this ABC formula is most commonly used in manufacturing, where
individual products are more easily costed. If you’re a service provider, this may not be
right for you. Discuss it with your accountant and see what their advice is.

Perhaps this isn’t something you want to adopt forever, but you are interested in
analysing your overheads and indirect costs and how they’re reflected in your pricing.

Another thing to bear in mind is that applying this formula becomes more
complicated when a company is more complex.

For example, you’re a baker. Your competitor just makes cookies. You make cookies,
whole cakes, loaf cakes, cupcakes and special occasion cakes. You’ll need to invest a
lot more time into your ABC strategy implementation than your competitor. Because
you’ve a lot more products to apply it to. You want to see if loaf cakes and cupcakes
are equally profitable, given that the former takes double the time in the oven. When
you add in that extra energy used, does it eat away the profit to a significant extent?
But you also want to see which flavours are the most profitable – the only thing your
competitor’s looking at.

As a more complex business, you get more benefit from applying Activity-Based
Costing methodology, but will it be worth the time investment?

You need to apply this logic to your business to see if Activity-Based Costing is the
best accounting method for you. There are other types of cost accounting that may
be more appropriate.

RELATED ARTICLES

Top 3 Online Depreciation Cost-Benefit Analysis: An How to Set Up a Direct Debit

Calculator to Calculate Extensive Guide for Payments
Depreciation

What Is Asset Management? How to Calculate the What Is a Dividend?

Definition & Importance Inventory Turnover Ratio for Definition, Example and How
Your Business They Work

Save Time Billing and Get Paid 2x Faster With FreshBooks Try FreshBooks Free Contact Sales

COMPANY FEATURES WHO IT’S FOR HELPFUL LINKS POLICIES

About Us All FreshBooks Freelancers Accountants Accessibility

Features
Blog Self-Employed Accounting Software Privacy Policy
Estimating Software Professionals
Careers Accounting Security Safeguards
Expenses and Businesses With Templates
Contact Terms of Service
Receipts Employees
Invoice Template
Our Story
Financial Reports Businesses With
Login
Press Center Contractors
High Volume Billing
Quickbooks
Invoice Software Alternative

Managing Projects Resource Hub

PARTNERS
Mobile Apps Sitemap
Affiliate Program
Online Payments Support
Apps
Pricing Support Webinars
Developers
Time Tracking Tools
Education

Referral Program

Reseller Program

United Kingdom

© 2000-2022 FreshBooks | Call Toll Free: 0808 101 3408