Activity-based costing is a costing method that allocates overhead not based on product output, but rather based on activity output. Managers assign indirect costs to products based on their consumption of overhead resources. In order to do this, managers use activity cost pools, which allocate overhead based on activity. This is particularly helpful for service companies and companies with high overhead.
At A Glance
Activity-based costing, a method that involves finding the manufacturing costs and nonmanufacturing costs of each activity involved in the production process and then assigning those costs to each product, can provide managers with a more accurate costing picture than traditional costing.
- Activity-based costing is popular in manufacturing as a more accurate alternative to costing systems that average overhead costs across a variety of products that vary in complexity.
- Managers use activity cost pools to develop activity cost drivers, or the measures of the number and amount of times an activity occurs, as well as rates, which are ratios of manufacturing overhead and total indirect costs, divided by a cost driver.
- Managers calculate activity rates by finding the ratio of manufacturing overhead and total indirect costs, using an activity cost driver to determine a rate.
- Activity-based costing can help managers make better decisions when they use it as a supplement to traditional costing.
- Managers can record activity pools separately when recording activity-based costs.
- Since managers often use activity-based costing as a supplement to another costing system, the manager needs to be able to reconcile both of them.