how activity based costing abc works
activity based costing abc is mostly used in the manufacturing industry since it enhances the reliability of cost data hence producing nearly true costs and better classifying the costs incurred by the company during its production process this costing system is used in target costing product costing product line profitability analysis customer profitability analysis and service pricing activity based costing is used to get a better grasp on costs allowing companies to form a more appropriate pricing strategy the formula for activity based costing is the cost pool total divided by cost driver which yields the cost driver rate the cost driver rate is used in activity based costing to calculate the amount of overhead and indirect costs related to a particular activity the abc calculation is as follows as an activity based costing example consider company abc that has a 50 000 per year electricity bill the number of labor hours has a direct impact on the electric bill for the year there were 2 500 labor hours worked which in this example is the cost driver calculating the cost driver rate is done by dividing the 50 000 a year electric bill by the 2 500 hours yielding a cost driver rate of 20 for product xyz the company uses electricity for 10 hours the overhead costs for the product are 200 or 20 times 10 activity based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities requirements for activity based costing abc the abc system of cost accounting is based on activities which are any events units of work or tasks with a specific goal such as setting up machines for production designing products distributing finished goods or operating machines activities consume overhead resources and are considered cost objects under the abc system an activity can also be considered as any transaction or event that is a cost driver a cost driver also known as an activity driver is used to refer to an allocation base examples of cost drivers include machine setups maintenance requests consumed power purchase orders quality inspections or production orders there are two categories of activity measures transaction drivers which involve counting how many times an activity occurs and duration drivers which measure how long an activity takes to complete unlike traditional cost measurement systems that depend on volume count such as machine hours and or direct labor hours to allocate indirect or overhead costs to products the abc system classifies five broad levels of activity that are to a certain extent unrelated to how many units are produced these levels include batch level activity unit level activity customer level activity organization sustaining activity and product level activity benefits of activity based costing abc activity based costing abc enhances the costing process in three ways first it expands the number of cost pools that can be used to assemble overhead costs instead of accumulating all costs in one company wide pool it pools costs by activity second it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures such as machine hours or direct labor costs finally abc alters the nature of several indirect costs making costs previously considered indirect such as depreciation utilities or salaries traceable to certain activities alternatively abc transfers overhead costs from high volume products to low volume products raising the unit cost of low volume products 1