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 cost accounting method 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.
KEY TAKEAWAYS
• Activity-based costing (ABC) is a method of assigning overhead and indirect costs—
such as salaries and utilities—to products and services.
• This system of cost accounting is based on "activities"; an activity is any event, unit
of work, or task with a specific goal.
• All activities are cost drivers: Purchase orders and machine setups are examples of
activities.
• The cost driver rate, which is the cost pool total divided by the cost driver total, 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.
An activity is an event, task, or unit of work with a specific purpose, whether it be designing
products, setting up machines, operating machines, or distributing products. Therefore,
activity-based costing considers all the potential activities instead of relying on just one
variable (for example, labor hours or machine hours).
Generally, activity-based costing is used in the manufacturing industry, as it produces more
accurate cost data, generating values that are close to the true cost and can be identified
during the production phase.
Activity-based costing serves and complements many other analyses and measures, including
target costing, product costing, product line profitability analysis, service pricing, and more.
Thus, it is used to better understand the company’s true costs, and thereby formulate an
appropriate pricing strategy to mitigate unnecessary expenses.
Key Highlights
• Activity-based costing is a way of allocating overhead costs based on “activities.”
This differentiates it from job-order costing, which allocates costs by a specific cost
driver like machine hours.
• An activity is an event, task or unit of work with a specific purpose, whether it be
designing products, setting up machines, operating machines or distributing products.
• Activity-based costing considers all potential cost activities instead of relying on just
one variable (labor hours or machine hours).
Labor Hours vs. Activity-Based Approach
Let take a look at the following example to compare the differences:
