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What is 'Activity-Based Costing (ABC)'

Activity-based costing (ABC) is an accounting method that identifies and assigns costs to overhead activities and then assigns those costs to products. An activity-based costing (ABC) system recognizes the relationship between costs, overhead activities, and manufactured 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 product. 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 company-wide pool, it pools costs by activity. It also 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, inspection, or power- 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.

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