Activity-Based Costing ABC: Method and Advantages Defined with Example

activity-based costing examples

Traditional allocation uses just one activity, such as machine-hours. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. A per unit cost is calculated by dividing the total dollars in each activity cost pool by the number of units of the activity cost drivers. activity-based costing examples As an example to calculate the per unit cost for the purchasing department, the total costs of the purchasing department are divided by the number of purchase orders. Once the per unit costs are all calculated, they are added together, and the total cost per unit is multiplied by the number of units to assign the overhead costs to the units.

Once in place, maintaining cost pools and micromanaging resources could eat into your bottom line. Pricing your products optimally requires an acute and accurate understanding of your costs of production. While traditional costing methods enable firms to allocate indirect costs at a single overhead rate, this method is subpar at best. Activity-based costing (ABC) resolves this issue by precisely assigning specific indirect costs to several products produced by the company. In traditional costing system, overhead costs are assumed to be influenced by only units produced. It means, in traditional costing system, cost of batch level, product level and facility level activities is fixed costs, i.e., costs of these do not change as production volume changes.

What is Activity-Based Costing?

Our writing and editorial staff are a team of experts holding advanced financial designations and have written for most major financial media publications. Our work has been directly cited by organizations including Entrepreneur, Business Insider, Investopedia, Forbes, CNBC, and many others. This team of experts helps Finance Strategists maintain the highest level of accuracy and professionalism possible. Some ABC systems rank activities by the degree to which they add value to the organization or its outputs.

  • It’s a step-by-step process of implementing activity based costing that yields results and can be an eye-opener to a manufacturer.
  • ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy.
  • Below, we’ll examine a few cons of implementing this cost accounting system.
  • We know from Example 1 that total labour hours required are 112,000.
  • Activity based principles can be successfully applied to the art of budgeting.

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). The fourth step will be calculating the cost driver rate, which is done by taking the total overhead cost of each cost pool and dividing it by total cost drivers. The labor hours approach is different in that you only require one cost driver. Often, direct labor or machine hours are the main activity in the manufacturing process. The traditional method allocates funds to this activity as the main one for the company.

Advantages of Activity-Based Costing

It means going into detail about each activity and how much it costs the company to perform. Each year, there are 2000 labor hours which is the main cost driver in this example. When you figure out the cost driver rate, you take the $30000 and divide it by the 2000 labor hours. Company ZC winds up with a cost driver rate of $15 after the calculation. Therefore, to make product X, you require about 8 hours which gives an overhead cost of $120. When you want to calculate the ABC, you need to take the sum of the pool total and divide it by the cost driver.

For example, is there any reason why Deluxe units have to be produced in batches of only 100? A batch size of 200 units would dramatically reduce those set-up costs. Step 4 then requires us to use the costs per unit of cost driver to absorb costs into each product based on how much the product uses of the driver. For Step 2 we need to identify the cost driver for each cost pool. Next, we discuss the methods used for
activity-based costing and illustrate them with an example. They’re usually based on at least some partly-estimated figures.

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Carla Sofia Guerreo Sanchez

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