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 Driver

    A factor that influences or contributes to the expense of certain ...
  3. Activity Cost Pool

    In managerial accounting, a set of costs which are incurred when ...
  4. Cost Accounting

    A type of accounting process that aims to capture a company's ...
  5. Activity Driver Analysis

    The identification and assessment of the factors that are involved ...
  6. Direct Cost

    A price that can be completely attributed to the production of ...
Related Articles
  1. Investing

    Explaining Activity-Based Costing

    Activity-based costing (ABC) is a managerial accounting method that assigns certain indirect costs to the products incurring the bulk of those costs.
  2. Investing

    What Are The Different Types Of Costs In Cost Accounting?

    Cost accounting measures several different types of costs associated with a company’s production processes.
  3. Investing

    Understanding Marginal Cost of Production

    Marginal cost of production is an economics term that refers to the change in production costs resulting from producing one more unit.
  4. Investing

    What are Direct Costs?

    Direct costs for finished goods refer to the items and services directly used in production. Other costs such as rent and insurance for the production site are indirect costs. These costs may ...
  5. 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 ...
  6. Small Business

    Calculating Production Costs

    Production cost is any expense associated with manufacturing a good or providing a service.
  7. Small Business

    What's Capitalization?

    Capitalization has different meanings depending on the context.
  8. Investing

    Explaining Prime Cost

    Prime cost is a way of measuring the total cost of the production inputs needed to create a given output.
  9. Investing

    Understanding Cost of Revenue

    The cost of revenue is the total costs a business incurs to manufacture and deliver a product or service.
  10. Investing

    What is Incremental Cost?

    Incremental cost is the added cost of manufacturing one more unit.
RELATED FAQS
  1. How can I tell if a cost is a direct cost?

    Find out how to tell if a cost is a direct cost, why that's important and why direct costs don't tell the whole story about ... Read Answer >>
  2. What are the differences between period costs and product costs?

    Find out why GAAP separates all company expenses into either period or production costs and how this impacts the way expenses ... Read Answer >>
  3. How are fixed costs treated in cost accounting?

    Learn how fixed costs and variable costs are used in cost accounting to help a company's management in budgeting and controlling ... Read Answer >>
  4. 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 >>
  5. 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 >>
  6. What is the difference between direct costs and variable costs?

    Learn about variable costs and direct costs, how direct costs and variable costs are classified and the differences between ... Read Answer >>
Hot Definitions
  1. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
  2. Cover Letter

    A written document submitted with a job application explaining the applicant's credentials and interest in the open position. ...
  3. 403(b) Plan

    A retirement plan for certain employees of public schools, tax-exempt organizations and certain ministers. Generally, retirement ...
  4. Master Of Business Administration - MBA

    A graduate degree achieved at a university or college that provides theoretical and practical training to help graduates ...
  5. Liquidity Event

    An event that allows initial investors in a company to cash out some or all of their ownership shares and is considered an ...
  6. Job Market

    A market in which employers search for employees and employees search for jobs. The job market is not a physical place as ...
Trading Center