What is activity-based costing and how does it work?

Activity-based costing or ABC is popularly referred to as a method of costing whereby overhead costs are assigned to products and services. This method of costing recognizes that a relationship exists between the costs incurred and every other activity going on in the business.

Activity-based accounting makes it possible to assign an indirect cost to different products or services offered by the business. This cost allocation is less arbitrary and more realistic than the traditional cost allocation methods. There are, however, some kinds of indirect costs that may be difficult to allocate to products.

How does Activity-Based Costing work?

The use of Activity-Based Costing is more common in industries where the manufacturing of products is carried out. The use of Activity-Based Costing in the manufacturing industry makes it possible to produce more reliable data. This helps the business to determine the cost incurred at each stage of the production process.

Some of the places this type of costing is applied are in areas like service pricing, analysis of the profitability of a business, profitability analysis of a line of product, determination of the cost of products, and others.

For instance, if a company’s electricity cost is $100,000, the amount of time spent in production will have an impact on the bill. The longer the labor hours, the more likely the electric bill will increase. Let’s say that for the year 2018, the company’s labor hours were 5,000. Labor hour is a cost driver. Therefore, the cost driver for company XYZ about the production is 5,000.

To calculate the cost driver rate, divide the amount of money spent yearly on electric bills by the number of labor hours. In this case, that would be $100,000 divided by 5,000. This will give you a total of $20. Therefore, the company makes use of electricity for 10 hours to manufacture the product ABC. The total overhead cost for product ABC incurred on electricity is $200 and the cost driver rate is $20.

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Objectives of Activity-Based Costing

There are several reasons why businesses use this costing method in cost allocation. Some of the reasons are as follows:

  • Activity-based costing as an alternative to traditional costing systems measures and allocates cost with a higher degree of accuracy and precision. This costing method try assigns costs per product thereby making it easy to determine the cost of producing each batch of product.
  • Activity-based costing helps businesses to understand the relationship between customer cost and the product being manufactured.
  • It measures profitability based on production processes. This helps businesses to have a grasp of their production process and how it impacts the company’s profit.
  • Activity-based costing helps the business to come up with a more structured analysis of even the most complex business process.
  • With this method of cost allocation, the management can have more accurate and comprehensive data that will positively affect or impact decision-making.
  • Activity-based costing enables businesses to separate the different activities of the business and get the cost implications for each. This helps the business to determine which activity yields the greatest benefit and which activity to eliminate.
  • With activity-based costing, businesses will be able to determine which activity yields the highest benefit and be able to allocate more time to it.

Characteristics of activity-based costing

Several characteristics differentiate activity-based costing from other costing methods. Some of the distinguishing features include:

  • Activity-based costing increases the cost pool that is used in gathering overhead costs. The total of cost pools accumulated over some time is highly dependent on the number of cost-driving activities. Costs are therefore accumulated based on specific activities and not departmental performance.
  • Unlike traditional costing, cost-based accounting allocates overhead costs to products or activities based on the number of cost-driving activities carried out per time. A traditional costing method allocates overhead cost based on the machine hour or the cost of labor.
  • Activity-based costing makes it possible to easily trace overhead costs. This helps in no small way to ensure accurate reporting as well as determine how well data will be managed.
  • Activity-based costing highlights activities that are not of so much value to the company. This helps the business to know the activities to give attention to and the ones that will bring down the production cost.
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Importance of activity-based costing (ABC)

There are so many benefits that companies and businesses can derive from the use of activity-based costing. The most pronounced benefit that businesses derive using this type of cost allocation method is the enhancement of costing. How does cost enhancement occur?

  • Expansion of cost pools: activity-based costing provides the business with ways of assembling overhead costs using varied cost pools instead of assembling the costs under one general pool. Costs are therefore accumulated based on the activity that is performed per time.
  • Introduces a new and better basis for overhead cost allocation to items. This allocation is done based on the activities carried out and not on the volume of products manufactured.
  • Makes cost traceable. Under this type of cost, some costs that are considered to be indirect can be traced to particular activities. Cost is also transferred to products that are produced in lower quantities thereby raising the cost incurred in producing a unit of the product.

Steps for calculating activity-based costing

The following steps should be taken in calculating activity-based costing.

#1. Determine the different activities

Before going ahead to calculate using this costing method, you must first determine the various activities that are involved in the manufacturing of different products in the organization. The volume and products manufactured differ from one organization to another.

The benefit derived from each activity must be commensurate with the cost allocated to it. At this point, there may be a need to run a cost-benefit to determine if the various activities where cost is incurred are worthwhile.

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#2. Determine the cost center for each activity

A cost center is simply the allocation of the total cost incurred to a particular group. Cost centers enhance traceability in costing.

#3. Define the cost driver

Cost drivers are series of activities that determine the cost of production. Any even air activity that has a significant impact on the cost of a product is a cost driver.

#4. Calculate the cost driver rate

To calculate the cost driver rate, simply divide the total cost by the cost driver.

#5. Charge the cost

The cost incurred in carrying out each activity will be charged to the production cost using the cost drivers. This is of course based on the volume of activities carried on within a specifics production process.


Decision-making is the life of any business. Management however does not decide out of the blues. There are various tools that managers employ over time to enhance good decision making and one of them is activity-based costing. Knowing how to apply this method in arriving at the cost implications of carrying out business will help you to maximize profits as well as make better decisions.