What is Activity-Based Costing (ABC)?
Activity-Based Costing (ABC) is a costing method that assigns overhead to products based on the specific activities that actually drive those costs, instead of one blanket volume-based rate. It gives more accurate product costs, especially for complex, low-volume products.
ABC assigns overhead costs to cost pools tied to activities (like machine setups or inspections), then allocates each pool to products using an activity rate: Cost Pool ÷ Driver Volume, multiplied by each product's actual driver usage.
- 1↓Identify activitiesList activities that consume resources, e.g., machine setup, inspection, order processing.
- 2↓Form cost poolsGroup overhead costs by activity into cost pools.
- 3↓Choose cost driversPick a measurable driver per pool, e.g., setup hours, number of inspections.
- 4↓Compute activity rateActivity Rate = Cost Pool / Total Driver Units.
- 5Allocate to productsAllocated Cost = Activity Rate × Product's Driver Usage.
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Step-by-step worked examples
A factory's 'Machine Setup' cost pool is $90,000 with 1,500 total setup hours as the driver. Find the activity rate.
Activity Rate = Cost Pool / Driver Units Activity Rate = 90,000 / 1,500 = $60 per setup hour
Using the $60/hour rate above, Product A uses 25 setup hours. How much setup cost is allocated to Product A?
Allocated Cost = Activity Rate × Driver Usage Allocated Cost = 60 × 25 = $1,500
A 'Quality Inspection' pool costs $40,000 with 800 total inspection hours. Product B uses 200 of those hours. Find its allocated cost.
Activity Rate = 40,000 / 800 = $50 per hour Allocated Cost = 50 × 200 = $10,000
Flashcards
Quick quiz
Q1.What does Activity-Based Costing primarily improve?
Q2.An activity rate is calculated as:
Q3.Which of these is an example of a cost driver?
Q4.Compared with traditional costing, ABC tends to reveal that low-volume, complex products were previously:
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Common mistakes
Assuming ABC always lowers total costs. — Correct: ABC only reallocates the same overhead more accurately among products — total overhead is unchanged.
Using one blanket rate for every activity. — Correct: ABC uses multiple activity rates, one per cost pool and its driver.
Ignoring low-volume products' driver usage. — Correct: ABC specifically corrects cost distortions for low-volume, complex products.
Treating cost drivers as fixed forever. — Correct: Cost drivers should be reviewed periodically as processes and operations change.
FAQ
What is Activity-Based Costing (ABC)?
ABC is a costing method that assigns overhead costs to products based on the activities that drive them, using multiple activity-specific cost drivers instead of one blanket rate.
What is the Activity-Based Costing formula?
Activity Rate = Overhead Cost Pool ÷ Total Driver Units. Allocated Cost = Activity Rate × Product's Driver Usage.
What are examples of Activity-Based Costing in practice?
Allocating machine-setup costs by setup hours, or quality-inspection costs by number of inspections performed per product line.
How is Activity-Based Costing different from traditional costing?
Traditional costing allocates overhead using one volume-based measure (like labor hours); ABC uses multiple activity-based drivers for more accurate product costs.