Activity Based Costing

Activity-based costing (ABC) is a system you can use to find production costs. It breaks
down overhead costs between production-related activities. The ABC system assigns costs to
each activity that goes into production, such as workers testing a product.
Manufacturing businesses with high overhead costs use activity-based costing to get a clearer
picture of where money is going. Because ABC gives specific production cost breakdowns,
you can see which products are actually profitable.

By using activity-based costing, you can:

● Take into consideration both the direct and overhead costs of creating each product
● Recognize that different products require different indirect expenses
● More accurately set prices
● See which overhead costs you might be able to cut back on

Activity-based costing vs. traditional costing

ABC provides an alternative to traditional costing. Traditional costing applies an average
overhead rate to direct production costs based on a cost driver (e.g., hours or volume).
But, some production-related activities use more overhead expenses than others. As a result,
traditional costing can give an inaccurate cost of making each product.
Traditional costing is simpler but less specific than activity-based costing. You might
consider going with traditional costing if you only make a few products.
You may also use traditional costing for reporting externally (e.g., to investors) and activity-
based costing for reporting internally (e.g., to managers).

Benefits and drawbacks of activity-based costing

Although an activity-based costing system gives you accurate production cost details, it can
be difficult to implement. That’s why you should consider the pros and cons before deciding
if it’s right for your business.

Benefits of activity-based costing

ABC costing can help with:

● Budgeting, Overhead decisions and Product pricing

Budgeting
When creating your budget for the year, you probably try to get as specific as possible when
it comes to your incoming and outgoing money.
Activity-based costing can help you to set an accurate budget that breaks down exactly where
your money is going—and which products are the most profitable.
Overhead decisions
The ABC system shows you how you use overhead costs, which helps you determine
whether certain activities are necessary for production.
Activity-based costing helps you identify where you’re wasting money. If you find that some
activities cost more than they should, you can find new methods to do something. Or, you can
cut out steps (and even products) entirely.
Product pricing
Another benefit of ABC is accurate product pricing. Pricing products can be one of the most
difficult decisions you make in business.
Failing to take all of your costs into consideration could result in setting your prices too low.
As a result, you might not wind up with a healthy profit margin.
With an ABC system, you can assign costs to each activity in the production process. This
shows you all the costs that go into producing a specific product. You can use this data to set
a price that more accurately accounts for how much it costs you to create the product.
Drawbacks of an ABC system
Before implementing this type of costing method, consider the cons:

● Complex
● Not 100% accurate

Complex
Activity-based costing is more complicated than traditional costing. Instead of general
overhead costs and production-related activities, you need to be specific.
How much time is Employee A spending on Activity XYZ? What about electricity—how
should you split up utility costs by activity?
Getting into the weeds can make it difficult to track data without an elaborate (and tried and
true) system. Not to mention, some businesses don’t have the job positions and resources to
manage an ABC system.
Not 100% accurate
Unfortunately, there isn’t a costing method that gives you a completely accurate breakdown
of your costs. So although an ABC system is more accurate and detailed than traditional
costing, it isn’t 100% accurate.
For example, the ABC system requires employees to track how much time they spend on
each activity (e.g., research, production, etc.). Your employees might miscalculate or even
exaggerate their time spent working on an activity.

Activity Based Costing Formula

Activity-Based Costing Formula = Cost Pool in Total / Cost

Driver

The ABC formula can be explained with the following core concepts.

● Cost Pool: This is an item for which measurement of the cost would require, e.g., a
product
● Cost Driver: It is a factor that will cause a change in the cost of that activity. There
are two kinds of cost driver:
○ 1) Resource Cost Driver: It is a measure of the number of resources that shall
be consumed by an activity. This will be used to assign the cost of a resource
to an activity. E.g., Electricity, Staff wages, Advertising, etc.
○ 2) Activity Cost Driver: This is the measure of the intensity of demand and
the frequency that is placed on the activities by the cost pools.
○ It will be used to assign the activity costs to a product or a customer. E.g.,
Material ordering costs, Machine set up costs, Inspection and testing charges,
Material handling and storing costs, etc.
Examples of Activity Based Costing

Let’s see some simple to advanced examples to understand it better.

Example # 1

BAC Ltd is considering shifting from the traditional costing method to ABC based costing
method, and it has got the following details. Using the ABC costing formula, find out the new
overhead rates for the company.

We have given two activities. The first one is a machine set-up activity, and the second one is
inspecting the same. So the number of machine setup would increase, the cost would also
increase, and similarly as the number of inspecting hours increases, that would lead to an
increase in inspection cost as well. Hence, we need to allocate those costs based upon their
cost drivers

Using the ABC formula: Cost Pool total / Cost driver

Calculation of Machine Setup Cost

Machine setup cost / Number of Machine setups

=2,00,000 / 340

Machine Setup Cost = 588.24

Calculation of Inspection Cost

Inspection cost /Inspection hours
=1,40,000 / 7500
Inspection Cost= 18.67
Example # 2

The following details pertain to different activities and their costs for Gamma Ltd. You are
required to calculate the overhead rate for each activity.

Below is given data for calculation.

We are here given five activities; hence, we need to allocate those costs based upon their cost
drivers.

Using the ABC formula: Cost Pool total / Cost driver

Each activity pool’s total cost is divided by its cost driver to arrive at different rates.

Overhead Rate for the Purchasing Activity

Overhead Rate for the Purchasing Activity = 1,20,000 / 200

Activity-Based Costing for Purchasing will be –

Overhead Rate for the Purchasing Activity =600.00

Similarly, do the calculation of ABC Cost Formula for all the cost pool activities
Total Estimated Overhead = 862500.00

Example # 3

Mamata Inc., a manufacturing company of drugs, is considering switching from their

traditional method of cost to a newly implemented system by their production head. It is
activity-based costing so that the two products Z serum and W serum can be sold at their
proper cost and make them price competitive in the market.

Below are the production details that have been derived from the production sheet.

You are required to arrive at product-based total cost using ABC formula.
We are here given six activities; hence, we need to allocate those costs based upon their cost
drivers.
Using the ABC formula: Cost Pool total / Cost driver
Each activity pool’s total cost is divided by its cost driver to arrive at different rates.
Overhead Rate for the Purchasing Activity

Overhead Rate for the Purchasing Activity = 60000/1000

For Purchasing, it will be –

Overhead Rate for the Purchasing Activity = 60.00

Similarly, do the calculation of ABC Cost Formula for all the cost pool activities

And the total estimated overhead is 506250.00

After arriving at different rates, we now have to arrive at product level total cost, which
would be nothing but multiplying different overhead rates as arrived above with their actual
cost drivers.

Relevance and Uses

It is a type of cost allocation process where it identifies all kinds of company’s costs and
allocates them to the costs of the products based on actual consumption.
It will enhance the process of cost in 3 different ways.
● First, it will expand the number of cost pools, which can later be used to assign those
overhead costs. So, it pools costs by activity instead of accumulating these costs in
one organization-wide pool.
● Second, instead of on volume measures like direct labour costs or machine hours, it
will create new bases to assign these overhead costs to items upon these activities,
which shall generate costs.
● Lastly, it makes the cost traceable to these activities.