What is Activity-Based Costing and How Does It Work (Explained)

What is Activity-Based Costing?

Activity-based costing is a process for computing production costs. It distributes overhead costs into different production-related activities. ABC is a procedure that applies overhead allocation to the products that utilize those activities, allowing it to be more exact than traditional allocation. ABC works effectively in complex processes where there isn’t a single cost driver driving the expenses.

Manufacturing companies with large overhead costs to gain a better view of where their money is going tend to use activity-based costing. It is easy to tell which products are genuinely profitable because ABC provides detailed production cost breakdowns. This strategy provides a clearer view of where a firm’s money is flowing and can help the company cut costs or price its goods more appropriately.

5 Necessary Steps Involved in Activity-based Costing

  1. Identifying the Activities – The number of production activities varies from product to product and from organization to organization. To determine the worthiness of any endeavor, a cost-benefit analysis can be performed.
  1. Establishing Cost Pool/Cost Centres for Each Significant Activity – A cost pool is a collection of total costs for every major activity. It simply refers to the distribution and allocation of various expenditures to a specific activity or group of activities. The whole cost of placing orders, for example, could be categorized under ordering costs.
  1. Determining Each Major Activity’s Cost Driver – The activities that determine the cost are known as cost drivers. Overhead costs are incurred because of these actions. As a result, a cost driver is an aspect or an event that origins a change in the total cost of the object. Three types of activity cost drivers can be identified:
  2. Transaction drivers – Transaction drivers include the number of transactions, which result in overhead expenditures, such as inspections, setups, and the number of purchase orders, among others.
  3. Duration drivers – Duration drivers determine how long it takes to complete an activity. Number of setup hours, inspection hours, and so forth are examples.
  4. Intensity drivers – It refers to the drivers who are responsible for directly charging for the resource consumed each time an action is completed.
  1. Activity Cost Driver Rate Calculation – It is found by dividing the overall cost of an activity by the cost driver, as displayed below.

Activity driver rate = Total cost of an activity/Cost driver

  1. Charging Activity Costs to the Product Costs – Activity costs will be charged to products using a cost driver rate based on the activities required by each product. As a result, both the machine-related set-up activity cost and the inspection activity cost will be charged to the product.
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Activity-based Costing Calculation

To use this costing method, one must first understand how costs are assigned to activities. The following formula can be used:

(Overhead for Cost Pool / Cost Drivers) x Amount of Activity Cost Driver

  • Cost pool is a group of separate costs connected to a single activity. By classifying the actions that go into creation of a product, cost pools can be created. Calculate the overall overhead when the costs into a pool are aggregated.
  • Cost driver is a feature that affects the activity costs. Labor, units or machine parts, and hours are some of the examples of cost drivers. For every cost pool, there can be one or more given cost driver.

Cost driver rate is found when the total cost drivers in a cost pool divide the total overhead.


The cost of inspection-related activities totals USD10,000. A batch of ten items in a batch necessitates ten inspection operations. The following is the cost-drives rate:

Driver rate for inspection = USD10,000/10

USD1,000 per batch.

Each product will incur a cost of USD1,000 for examination (10,000 for a batch of 10 items in a batch). Other costs will also be added to the product in order to compute the overall cost incurred.

Activity Based Costing – Top four Stages

Accountants must follow the four steps in activity-based costing:

  1. All cost-generating operations in the factory are identified. Design modifications, inspections, material requisitions, material movements, and machine setups are examples of these activities.
  2. Identify the cost drivers that each task entails. A cost driver is a transaction or activity that results in the occurrence of costs. The amount of orders engaged or the quantity of pieces ordered could be cost drivers in the acquiring of material activity. There could be several cost factors for each action.
  3. The estimated number of units (cost drivers) then divides the projected costs of each activity in the activity to reach an overhead activity rate that is used to charge overheads to each product, job, or service depending on the number of units.
  4. Allocate expenses to items by multiplying the cost driver rate with the amount of cost driver parts the items consume.
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Detailed Description of How These Four Stages Work

Stage 1 of the activity is usually the most intriguing and hardest. This step necessitates that individuals comprehend all of the steps involved in creating the product. The teaching of activity-based costing is that indirect costs rise with the complexity of the firm.

The cost drivers are identified in Stage 2. The majority of cost factors are connected to production volume or the difficulty of the manufacturing or marketing course. Managers evaluate three factors when determining which cost drivers to use:

  • Causal relationship – It is best to pick a cost driver that sources the cost.
  • Obtained benefits – Pick a cost driver that assigns costs in proportion to the benefits received.
  • Reasonability – Some costs are allocated based on rationality because they cannot be associated to products centered on causality or profits obtained.

The activity rates must be calculated for Stage 3. This is done by the means of the same predetermined overhead rate algorithm as in traditional costing. Fixed rates for assigning secondary costs to items are calculated in the following way:

Predetermined Overhead Rate (POHR) = Estimated Overhead / Estimated Base (or cost driver)

It can be used to calculate all secondary costs, including production overhead, distribution costs, administrative costs, selling charges, and any other type of unforeseen cost.

Stage 4 begins by defining the concept of an activity center. It is a part of a company that is involved in accomplishing a certain task. The costs of arranging machinery, for example, would be allocated to the activity center that does so. This indicates that there are expenses connected with each activity. When the number of inspections is the cost driver, for example, the organization must keep a check on the inspection costs. For each task, the following formula should be used:

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Applied Overhead = amount of activity cost driver x activity POHR

Advantages and Disadvantages of Activity-Based Costing

Activity-based costing improves the costing procedure in three approaches.

  • Firstly, it increases the amount of cost pools available for assembling overhead charges.
  • Secondly, it generates fresh grounds for transmission of overhead costs to possessions, letting the overheads to be distributed depending upon the cost-generating actions rather than volume metrics.
  • Lastly, ABC modifies the nature of some secondary costs, permitting formerly intangible expenditures like utilities, depreciation, and salaries to be drawn back to particular accomplishments.

While ABC costing can be an actually operational technique to accomplish the business’s assets, it might not be particularly beneficial if:

  • Overhead is just a minor portion of the complete cost associated with the items or service.
  • Distributing all of the total overheads to particular events may be unreasonable.
  • The profits of ABC costing may not continuously compensate the additional cost.