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 tend to use activity-based costing to gain a better view of where their money is going.

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. A cost-benefit analysis can be performed to determine the worthiness of any endeavor.
  1. Establishing Cost Pool/Cost Centres for Each Significant ActivityzA 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. For example, the whole cost of placing orders could be categorized under ordering costs.
  1. Determining Each Major Activity’s Cost DriverThe 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 that result in overhead expenditures, such as inspections, setups, and purchase orders, among others.
  3. Duration drivers – Duration drivers determine how long it takes to complete an activity. A number of setup hours, inspection hours, and so forth are examples.
  4. Intensity drivers – These refer to the drivers who are responsible for directly charging for the resource consumed each time an action is completed.
  1. Activity Cost Driver Rate CalculationIt is found by dividing the overall cost of 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 CostsActivity 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

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

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

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

The cost driver rate is found when the total cost drivers in a cost pool divide by 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. These activities include design modifications, inspections, material requisitions, material movements, and machine setups.
  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 number of orders engaged or the number of pieces ordered could be cost drivers in acquiring 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 firm’s complexity.

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 with products centered on causality or profits obtained.

The activity rates must be calculated for Stage 3. This is done using 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 unforeseen costs.

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, the organization must check 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 number of cost pools available for assembling overhead charges.
  • Secondly, it generates fresh grounds for transmitting overhead costs to possessions, letting the overheads be distributed depending on 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 services.
  • Distributing all of the total overheads to particular events may be unreasonable.
  • The profits of ABC costing may not continuously compensate for the additional cost.