Definition of Activity-Based Costing
Traditional costing is a system of accounting in which overhead expenses are placed into a single pool and distributed based on a predetermined rate. In traditional costing, overhead is a period cost that is generally applied to the company; it is not associated with a specific activity or product. In contrast, activity-based costing (ABC) is an accounting method in which expenses for overhead are distributed to manufactured items on the basis of the activities required.
An activity is any event or task that causes the consumption of overhead resources. For example, setting up the equipment needed to produce a product would be an activity. The manager takes an activity in a department, breaks down that activity into parts to determine the costs for the activity, and then reports on each part of the activity. This type of costing shows managers whether there are specific costs that affect the activity more than other costs do.
Activity-based costing traces all costs incurred that directly affect the development, production, and shipping of the product. An activity cost pool is a combination of all the expenses related to a specific task, such as making a product or providing a service. An activity cost driver is a unit of manufacturing action that creates a change in the unit's expense. A driver is anything that triggers a change. An activity cost driver is the fundamental reason that an activity has an expense. For a manufacturer, the common drivers are raw materials and labor used to create the products. Less easily attributed cost drivers are the expenses for maintaining the machines that are required to make the products.
There are two categories of drivers in activity-based costing: transaction and duration. Transaction drivers are an activity measure; they give the quantity of an activity that creates the activity costs in a cost pool. Typical transaction drivers are the number of orders completed and the number of units shipped. Transaction drivers generally use a number of items as their unit of measurement. Duration drivers measure how long the activity takes. For example, some companies use the time to process an order and the time for delivery as duration drivers. Duration drivers measure time, which is reflected in the units of measurement. Activity-based costing uses a costing approach to help managers make decisions on costs related to fixed-cost and variable-cost drivers.
In activity-based costing, the manager allocates expenses to a cost object—or, more likely, several cost objects. A cost object is any item for which a business measures costs; for example, a product, service, department, or activity. It derives from a resource that is used in the activity. A resource can be materials or labor to create the item. Anything that is significant enough to measure can be a cost object.
A difference between activity-based costing and traditional costing is that some manufacturing costs may not be included in product costs under traditional costing. Commissions, shipping, and warranties are all costs that relate to the number of units but do not readily lend themselves to direct measurement.
The difficulty of applying a particular cost depends on the frequency of that cost. A unit-level activity is an activity that occurs every time a unit is produced, giving a proportional cost per unit created. For instance, if a company makes pencils, then each time line workers produce a pencil, attaching an eraser to that pencil will be part of the task. Costs associated with unit-level activities tend to be easier to apply because they happen along with the production of each unit.In contrast, a product-level activity is a product-specific process that must be carried out regardless of the number of units produced or batches run. For example, if a pencil manufacturer changed the way it made pencils, that would be a product-level activity. The costs of making changes to the production process are associated with product-level activities and occur regardless of the number of units made. Traditional costing systems, on the other hand, calculate volume measurement as direct labor or direct machine-hours costs and then allocate those expenses to overhead costs based on the product.
Activity-Based Costing Overview
Examples of Use of Activity-Based Costing
For some companies, it works well to allocate overhead based on direct labor hours or machine-hours. This worked especially well historically, when companies manufactured a more limited array of products. Overhead was low, and indirect costs represented a relatively small portion of total costs. Broad averaging could be used to allocate overhead costs across a variety of products. But activity-based costing recognizes that products or services may be using overhead costs nonuniformly.
Activity-based costing is popular in manufacturing, where there is overhead and product cost. When a product is manufactured, there are costs that are simple to apply to the product, such as the direct materials required to make the item; there are also overhead costs that need to be assigned. Megalith Manufacturing is a producer of widgets. Megalith makes two different types of widgets with different features. Product A is more complex than Product B. If Megalith allocates overhead to the two products equally, the more complex product may end up being undercosted, or reported to have a lower per-unit cost than it actually does, while the simpler one may end up overcosted, or reported to have a higher per-unit cost than it actually does. This may, in turn, cause Megalith's managers to make decisions about investing in and promoting the two products that are based on inaccurate information.
The managers at Megalith, therefore, decide that activity-based costing will be a more accurate way for them determine costs. Setting up an activity-based costing process will help Megalith's managers trace all costs incurred that directly affect the development, production, and shipping of Product A and Product B. Their first step will be to identify the activities that will form the basis of their activity-based costing system.
Because of activity-based costing's focus on activities, managers who use it are often better able to pinpoint areas where savings are possible than those who use traditional costing. For this reason, many managers use activity-based costing as a supplement to either traditional costing or another costing system.