Activity-Based Costing - ABC

Loading the player...

What is 'Activity-Based Costing - ABC'

Activity-based costing (ABC) is an accounting method that identifies the activities that a firm performs and then assigns indirect costs to products. An activity-based costing (ABC) system recognizes the relationship between costs, activities and products, and through this relationship, it assigns indirect costs to products less arbitrarily than traditional methods.

Some costs are difficult to assign through this method of cost accounting. Indirect costs, such as management and office staff salaries are sometimes difficult to assign to a particular product produced. For this reason, this method has found its niche in the manufacturing sector.

BREAKING DOWN 'Activity-Based Costing - ABC'

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. It is also hugely popular since organizations can develop a much better corporate focus and strategy if costs are better grasped.

Definition of Activities in ABC System

The ABC system of cost accounting is based on activities, which is any event, unit of work or task 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, power consumed, purchase orders, quality inspections or production orders.

There are two categories of activity measures: transaction drivers, which involves 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.

How ABC System Improves Costing Process

Activity-based costing 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 companywide pool, it pools costs by activity. It also creates new bases for assigning overhead costs to items such that costs are allocated on the basis of the activities that generate costs instead of on volume measures such as machine hours or direct labor costs. Finally, ABC system alters the nature of several indirect costs, making costs previously considered indirect such as depreciation, inspection or power are traced to certain activities.

However, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

RELATED TERMS
  1. Activity Center

    A pool of activity costs associated with particular processes ...
  2. Activity Cost Pool

    In managerial accounting, a set of costs which are incurred when ...
  3. Activity Driver Analysis

    The identification and assessment of the factors that are involved ...
  4. Production Cost

    A cost incurred by a business when manufacturing a good or producing ...
  5. Overhead Rate

    In managerial accounting, a cost added on to the direct costs ...
  6. Applied Cost

    A term used in cost accounting to denote the cost assigned to ...
Related Articles
  1. Investing

    What is Absorption Costing?

    Absorption costing is an accounting method primarily used in manufacturing. In absorption costing, the cost of a manufactured product includes the direct costs plus an apportioned share of the ...
  2. Investing

    What's Capitalization?

    Capitalization has different meanings depending on the context.
  3. Economics

    Calculating Production Costs

    Production cost is any expense associated with manufacturing a good or providing a service.
  4. Investing

    Examining Costs Of Goods Sold (COGS)

    Learn more about the costs that go into production.
  5. Term

    What is Incremental Cost?

    Incremental cost is the added cost of manufacturing one more unit.
  6. Economics

    Explaining Cost Control

    For a business, cost control entails managing and reducing expenses.
  7. Economics

    Explaining Cost Of Capital

    Cost of capital is the cost of funds used to finance a business.
  8. Economics

    What are Acquisition Costs?

    A company can recognize acquisition costs as those costs used to buy property and equipment.
  9. Investing Basics

    What Determines Your Cost Basis?

    In any transaction between a buyer and seller, the initial price paid in an exchange for a product or service will qualify as the cost basis. When it comes to securities and related financial ...
  10. Economics

    How Do Accountants Use the Equity Method?

    The equity method is an accounting technique used by firms to assess the profits earned by their investments in other companies.
RELATED FAQS
  1. What are the different types of costs in cost accounting?

    Learn about the different types of costs associated with cost accounting, such as direct, indirect, fixed, variable and operating ... Read Answer >>
  2. How is the marginal cost of production used to find an optimum production level?

    Understand more about production cost calculations, and specifically how the marginal cost of production is used to determine ... Read Answer >>
  3. How do fixed and variable costs each affect the marginal cost of production?

    Learn about the marginal cost of production, how to calculate the marginal cost, and how fixed costs and variable costs affect ... Read Answer >>
  4. How is overhead distributed through total absorption costing?

    Learn how overhead is distributed through total absorption costing, and the steps required for a company to determine its ... Read Answer >>
  5. How do some contra account types reduce book value?

    Look at a brief example of how cost accounting treats overhead expenses, how those expenses are different from direct labor ... Read Answer >>
  6. What is the difference between prime cost and conversion cost?

    Understand the difference between prime costs and conversion costs, and learn how each type is used in analyzing business ... Read Answer >>
Hot Definitions
  1. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  2. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  3. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  4. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  5. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
  6. Unlevered Beta

    A type of metric that compares the risk of an unlevered company to the risk of the market. The unlevered beta is the beta ...
Trading Center