Activity-Based Costing (ABC): Complete Guide

An accurate calculation and pricing of goods, products, and services are one of the challenging tasks to tackle for business owners and manufacturers. It only requires an “Exact Right Price” of goods and services. This is what attracts any customers automatically because of realistic transparency and because of worthy pricing. It makes a rise in the margin graph and gives a good profit. 

But let me tell you, this is not as easy as making a cup of tea, it takes dealers to consider all the account factors where you are standing in the market, have knowledge of what competitors are doing, and make a profit without discouraging the customers. 

With Activity Based Costing, products and service businesses can get into the core details to allocate the expenses in a better way. That means you can more precisely examine your expenditure and the price of your products. Now, let me help you develop a better understanding of the activity-based costing, with the help of this article: 

What is Activity Based Costing?

Activity-Based costing (also known as ABC costing) defines as a costing technology that identifies the activities of an organization and allocates the cost of individual products and services based on the actual usage of each product. Therefore, this method gives an idea of indirect cost into direct cost compared to conventional costing. 

Manufacturing and mass-producing businesses with overhead costs use Activity-Based costing to have a clear understanding of where investment is going. Activity-Based costing objectives give a detailed breakdown of the cost, where you can make a list of the actually profitable products.  

By using Activity-Based costing: 

• It helps to know about direct pricing products as well as the products which are overwhelming in cost. 
• It helps to identify the requirements of various products which are required for an indirect expense. 
• Using activity-based costing helps to set the pricing strategy more accurately. 
• ABC also helps to identify which overhead product cost can be refactored. 

Important Terms Used in Activity-Based Costing

The process of the ABC system involves the use of the following terminologies: 

1. Cost Object

• It indicates an item for which the cost is calculated using the ABC costing system. 
• For example: a service, customer, or product. 

2. Cost Driver

• A cost driver is any factor or force that causes a change in the cost of an activity. 
• Cost drivers can be divided into two types: 
  • Resource cost driver 
    • The quantity measure of the resource utilized by an activity is known as Resource Cost Driver. 
    • It is used to assign the cost of a resource of an activity or a cost pool 
  • Activity cost driver 
    • An activity cost driver is measuring the frequency and the demand by the cost items. 
    • It is used to assign the activity cost to cost objects. 
    • For example: promotions, manufacturing, research, and development 

How Activity Based Costing Work?

Now, let’s dive deep into Activity-based costing process on how it works internally. Here are step-by-step instructions which give an in-depth idea of the Activity Based Costing process: 

• First, consider all the activities that contribute to the manufacturing of a product. Then split up all these activities into a cost pool (i.e., a total of all the costs that comes under a particular task).  
• For example: Separating, one cost pool under customer service, another under order processing, and a few others which belong to none could be added to the category as others.  
• Now, allocate overheads to the different cost pools. To check which overhead belongs to which cost pool can be identified either by making an estimate or by interacting with the employees who have a deeper knowledge of it.  
• In the next stage, you need to identify to calculate the activity rate. To do this, divide the total cost which is associated with each of other cost pool by the cost driver. 
• For example: the customer support cost pool could be around £25,000 which can be divided by 30,000 customers. 
• Finally, we can multiply the activity rate by the cost measurement, which determines the per unit rate, which then can be used to add all the total rates which come under indirect costs associated with all the goods and services. Also, you can look into the useful areas where how Activity-based costing - project mgmt certification can be applied. 

Activity Based Costing vs Traditional Costing

The list of differences between Activity Based Costing vs Traditional costing is given below: 

Boundary of Comparison	Activity Based Costing	Traditional costing
Definition	ABC is majorly used for finding the indirect costs.	Traditional costing is for finding the cost for the products in advance.
Primary focus	ABC uses multiple cost drivers for multiple activities.	It used identical cost drivers for different activities.
Scope	ABC covers only product costing	Traditional costing covers both products as well as period costs.
Usage	Can be used in external financial statements.	Traditional costing cannot be used in reports of external costing.
Pricing strategy	It is a less expensive costing method.	It is expensive.
Types of activity performed	It can be utilized at the Unit level, Facility level.	Traditional costing can be utilized at Unit Level, Facility level, product level and batch level.

Concluding the differences between Traditional based costing and Activity-based costing, traditional costing is a conventional method of costing, and it is an easy-going method for management. Also, the usage of Traditional costing is suitable for all types of companies that have a low set of costs.

Activity Based Costing Calculations

ABC calculations can be given below: 

• Identifying all the activities which are required for manufacturing the product. 
• Divide the activities into a cost pool. It could include individual costs related to activities such as manufacturing. 
• Calculating the total overhead of each cost pool. 
• Assigning each cost pool activity cost drivers, for example as hours per unit. 
• Calculate the cost driver rate by dividing the total overhead of all the cost pools by the total cost drivers.  
• Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate.  
• Multiply the cost driver rate by the number of cost drivers.  

1. Activity Based Costing formula

Activity Based costing (ABC) is a method to determine the total cost of manufacturing a product, including overhead. It is calculated by taking the total cost pool and dividing it by the cost driver. Identifying product pricing can have a significant impact on a business and allows it to increase its revenue and profit margin when done correctly.  

The formula for Activity based costing is as follows: 

ACTIVITY BASED COSTING = COST POOL TOTAL / COST DRIVER  

2. Step-by-step breakdown of the formula

The ABC formula can be described with the core concepts below: 

1. Cost Pool: 

This is a product or an item to which the measurement of the cost would require. 

     2. Cost Driver: 

It is a component that will add a change in the cost of the activity. There are two kinds of cost drivers: 

• Resource Cost Driver: It measures the number of resources that an activity can consume. It can be used to assign the cost of resources to an activity. And we can also check the PMP online course which indirectly relates to ABC along with the PRINCE2 course   
  • For example: Electricity, staff wages, advertising etc. 
• Activity Cost Driver: This is the measure of the intensity and demand of the frequency placed on the activities by the cost pool. It will assign the activity costs to services or products or to a customer.  
  • For example: Machine setup costs, Material ordering costs, inspection and testing charges, Material handling and storage costs etc. 
• To Identify all the activities that come under creating products. 
• Separating each activity into groups. For example: The product line 
• Finding the total overhead for each of the cost pools. 
• Assigning the activity cost drivers like unit, parts, and hours which control changes in the cost to each group. 
• Multiplying the cost driver rate by the amount of activity of cost drivers. 

Using the above given ABC formula: Cost Pool total / Cost Driver, the calculation of Machine setup cost is equal to: 

3. Estimating the cost per time unit of capacity and estimating the unit times of activities 

• Cost per unit time of capacity includes the activity rate by the customer. 
• After calculating the total activity rate, divide the total cost associated with each of the cost pools by the cost driver. 
• In the end, multiplying the above activity rate by the cost driver determines the per unit time of rate or capacity.  

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

In the above example, it is given five activities, we must allocate the cost based on the cost drivers. 

Formula - Cost Pool total / Cost driver 

Each activity pools total cost into its cost driver to get distinct rates. 

Overhead rate of activity = 1,20,000 / 200 

Activity based costing purchase is equal to  

Now the overhead rate of Purchased activity will be = 600.00 

Similarly, find out the ABC cost formula for all activities. 

Now the total estimated Overhead = 862500.00 

4. Deriving cost-driver rates

The impact of practical capacity 

Concerning the management customer service department, the survey of ABC work can be distributed about 70%, 20% and 10% of the time where employees spend time on the three activities. But this time can reflect how each employee utilizes and spends it in a productive way. But in the real scenario, the productive time spent is less than the actual time of 32 hours per employee per week was discarded. The calculation of the employees' cost of time estimation will go inappropriately, so the ABC cost drivers give accurate data about the cost and the efficiency of the process. 

For calculating the cost driver: 

Cost driver rate = total cost of Finishing activity per day / Cost Driver Units  

== 40 total cost / 8 hours a day = $5 

5. Updating the model

In the business organization, higher-level administrations can update their ABC costing model which can reflect changes in the system. It helps to bring up new product services to the business and the estimation can be done directly to get the unit time needed for each recent activity, instead of hiring resources. 

The administrative team can also produce their own set of rates for cost-driven activities. In that majorly there are two factors which affect these changes in rates. 

• First, a change in the rate of products that are already supplied can affect the cost rate per unit of time. 
  • Example: There will be a compensation increase of 8% for an employee, and the resource cost will increase from $0.80 to $0.864 per minute. The resource cost rate is again modified if new products are added to the process. 
• Also, we can say that shift-efficient activity can also add to the change in the rate of activity cost-driver. The quality of activity programs, continuous integrations and improvements, and reengineering can do the same in less time with fewer employees or resources. 

6. Time equations to capture the complexity

In capturing the complexity, we were dependent on the assumption that all transactions are either same or there might be the same amount of time to process the data. But Time-driven ABC costing is not in demand for this type of simplification. To simplify, estimating the process and producing a more accurate cost model than the one which could be possible using traditional ABC techniques. 

The time-driven approach to Activity Based Costing can simplify the complexities of business than that of the traditional ABC costing system, which might take each process variant as a distinct activity. 

Example: Consider a case, the Hunter Corporation (not the original name), a large, multinational distributor of scientific services, whose 27 facilities process more than one million orders each month to distribute up to 300,000 different product SKUs to 25,000 customers.  

Its old ABC model required the employees of its own sales department to estimate each month the percentage of their time that they spend on three activities:  

• customer setup 
• order entry 
• order expediting. 

With the time-driven approach, Hunter’s ABC team of analysts was able to combine the three activities into a single departmental process, called inside sales order entry and it took about: 

• 5 minutes to enter the basic order information 
• 3 minutes for each line item 
• an additional 10 minutes if the order had to be expedited.  
• If the customer were new, 15 more minutes would be required to set up the customer in the company’s computer system. 

So, it was replaced by a single-time equation: 

Inside Sales, Order Entry Process Time = 5 + (3 × number of line items) + 15 [if new customer] + 10 [if expedited order] 

And this was straightforward to implement and easy to understand and resolves by saving time. 

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Requirements for Activity Based Costing

The Activity Based costing system requires the following: 

• Setting up a requirement information system could help trace all the cost-to-cost of the objects. 
• End-to-end support from top to bottom line involves people at all levels. 
• Integration of system into financial and accounting firms. 

To finalize the ABC systems are those of adoption, implementation, and operation of the system is not end. The benefits could be translating the system designs and operations into action-oriented performance. Finally, it amounts to effective cost management for the success of the system. 

Activity Based Costing (ABC) Advantages and Disadvantages

There are several important benefits associated with activity-based costing. It gives a more accurate overview of products or services of costing. 

Advantages of Activity Based Costing

• It provides the actual cost of production of specific products. 
• It allocates manufacturing overhead accurately to products and processes that use those activities. 
• Identifies inefficient products and sets targets to reach the goal of improvements. 
• Determines product's profits margin more precisely. 
• Evaluates the processes which have waste and unnecessary costs.  
• Provides better justification of costs in overhead manufacturing. 

Disadvantages of Activity Based Costing

• Collection and preparation of ABC costing is time-consuming. 
• It takes huge cost to accumulate and analyze the information. 
• Source data will not be available readily from normal accounting reports. 
• Reports from ABC are not always useful for all types of accounting principles and cannot be used for external reporting. 
• ABC costing may not be as useful for companies where overhead is small in proportion to total operating costs. 

Bottom line to Be Concluded As

To conclude, Activity-Based costing as it is a way of analyzing the organization’s costs to optimize the profit margins. If ABC costing is implemented with the correct understanding of the purpose, it can return great long-term value to the organization. 

The ABC costing system gives a more accurate and cleaner picture of the production process and the costs associated with each area of production. This allows us to analyze the process and determine the areas that are functioning appropriately and which other areas might need improvement. Activity based costing with project management and its complete guidance can be found in the KnowledgeHut training for Project Management.