Activity-Based Costing (ABC)

Activity-based costing uses cost drivers to assign the costs of resources to activities, along with unit cost as a way of measuring output.

Steps to Implement Activity-Based Costing

The four steps involved in activity-based costing (ABC) are described below.

1. Identify ABC Activities

Perform an in-depth analysis of the operating processes of each responsibility segment. Each process may involve one or more activities, as required by outputs.

2. Assign Resource Costs to Activities

This step is sometimes called “tracing.” Traceability uses tracing costs in order to cost objects, thereby determining why costs were incurred. These can be categorized in three ways:

Direct 

Costs that can be traced directly to one output. Example: the material costs (varnish, wood, paint) to build a chair.

Indirect

Costs that cannot be allocated to an individual output; in other words, they benefit two or more outputs, but not all outputs. Examples: maintenance costs for the saws that cut the wood, storage costs, other construction materials, and quality assurance.

General & Administrative 

Costs that cannot reasonably be associated with any particular product or service produced (overhead). These costs would remain the same no matter what output the activity produced.

Examples: salaries of personnel in the purchasing department, depreciation on equipment, and plant security.

3. Identify ABC Outputs

Identify all of the outputs for which an activity segment performs activities and consumes resources. Outputs can be products, services, or customers (persons or entities to whom a federal agency is required to provide goods or services).

4. Assign Activity Costs to Outputs

Assign activity costs to outputs using activity drivers. Activity drivers assign activity costs to outputs based on individual outputs’ consumption or demand for activities.

For example, a driver may be the number of times an activity is performed (transaction driver) or the length of time an activity is performed (duration driver).

Activity-based costing encourages managers to identify which activities are value-added—those that will best accomplish a mission, deliver a service or meet customer demand.

It improves operational efficiency and enhances decision-making through better, more meaningful cost information.

Example: Activity-Based Management

John Corporation manufactures special packaging boxes for the pharmaceutical industry. The company’s Zedan plant is semi-automated, but the special nature of the boxes requires some manual labor.

The plant controller has chosen the following activity-based cost pools, cost drivers, and pool rates for the Zedan plant’s product costing system.

Activity Cost Pools Overview

Two recent production orders had the following requirements.

Two Production Orders

Required:

  1. Calculate the pool rates for each activity.
  2. Compute the total overhead that should be assigned to each of the two production orders.
  3. Compute the overhead cost per box in each order.
  4. Suppose the Zedan plant was to use a single predetermined overhead rate based on direct labor hours. The direct labor budget calls for 8,000 hours.
    • Compute the predetermined overhead rate per direct labor hour
    • Compute the total overhead cost that would be assigned to both of the above
    • Compute the overhead cost per box in each order

Solution

1. Pool rates

Pool Rates

2. Total overhead assigned

Overview of Total Overhead Assigned to Activities

3. Overhead cost per box

Calculation of Overhead Cost per Box

4. Predetermined overhead rate

Calculation of Predetermined Overhead Rate

5. Assignment of overhead costs

Assignment of Overhead Costs for Two Orders

Activity-Based Costing PDF Download

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