Activity based costing

What Is Activity-based Costing?

Activity-based costing (ABC) is a method of cost accounting that assigns overhead costs and indirect costs to products and services based on the actual activities that consume resources. Unlike traditional allocation methods that might broadly distribute overhead, ABC identifies specific activities and their associated cost drivers to provide a more accurate picture of costs incurred. This approach falls under the broader financial category of cost accounting, aiming to enhance a company's understanding of its cost structure and improve decision-making regarding pricing, profitability analysis, and overall cost management.

History and Origin

Activity-based costing gained prominence in the late 1980s, emerging as a response to perceived shortcomings in traditional management accounting systems. The foundational ideas were notably articulated by Robert S. Kaplan and H. Thomas Johnson in their influential 1987 book, Relevance Lost: The Rise and Fall of Management Accounting.²⁰ Their work highlighted how existing accounting methods, designed for an industrial era with a high proportion of direct labor and material costs, were becoming less relevant for modern businesses characterized by increasing automation and a larger share of indirect costs.¹⁹ Kaplan and Johnson argued for a system that could more accurately trace costs to specific activities and, subsequently, to products, addressing the limitations of volume-based allocation that often distorted true product profitability.¹⁷, ¹⁸ The Chartered Institute of Management Accountants (CIMA) further defined ABC as an approach for costing and monitoring activities that involves tracing resource consumption and costing final outputs.¹⁶

Key Takeaways

• Activity-based costing allocates indirect costs to products or services based on the specific activities that drive those costs.
• It provides a more accurate and realistic assessment of product costing compared to traditional methods, especially for companies with diverse product lines or complex operations.
• ABC helps identify the most resource-intensive activities, enabling better cost control and strategic decision-making.
• The methodology involves identifying activities, forming cost pools, determining cost drivers, and then applying cost driver rates to allocate costs.
• While offering enhanced accuracy, implementing activity-based costing can be complex and resource-intensive, requiring significant data collection.

Formula and Calculation

The core of activity-based costing involves a two-stage allocation process:

1. Stage 1: Assigning Costs to Activity Pools

   • Gather all overhead costs and assign them to relevant activity pools. For example, machine maintenance costs, setup costs, or quality inspection costs would each form a cost pool.

2. Stage 2: Calculating Cost Driver Rates and Allocating to Cost Objects

   • For each activity pool, identify a suitable cost driver, which is a factor that causes a change in the cost of an activity.
   • Calculate the cost driver rate using the following formula:
   $$\text{Cost Driver Rate} = \frac{\text{Total Costs in Activity Pool}}{\text{Total Activity Driver Volume}}$$
   • Finally, allocate the activity costs to specific products or services (cost objects) based on their consumption of the cost driver:
   $$\text{Allocated Activity Cost} = \text{Cost Driver Rate} \times \text{Number of Cost Driver Units Consumed by Product/Service}$$

For example, if a "Machine Setup" activity pool has total costs of $10,000 and there are 500 machine setups in a period, the cost driver rate would be $20 per setup. If a product requires 10 setups, it would be allocated $200 in machine setup costs. This process ensures that costs are linked to the specific actions that generate them, providing a detailed understanding for budgeting purposes.

Interpreting Activity-based Costing

Interpreting the results of activity-based costing involves understanding how costs are truly incurred across different operations and products. Unlike simpler methods that might broadly apply overhead based on direct labor hours or machine hours, ABC reveals the specific activities that consume resources. For instance, a product that appears highly profitable under traditional costing might be less so under ABC if it requires a disproportionately high number of non-production-volume-related activities, such as custom setups, frequent quality inspections, or complex customer service interactions. This granular insight allows management to identify inefficiencies, re-evaluate product designs, or adjust pricing strategies to reflect the actual cost of production and delivery. It empowers better resource allocation and supports more informed operational decision-making.

Hypothetical Example

Consider "TechGadget Inc.," a company that manufactures two products: a high-volume, standard smartphone charger (StandardCharge) and a low-volume, specialized wireless charger (AeroCharge).

Traditionally, TechGadget allocated all manufacturing costs based on direct labor hours. However, the company suspects AeroCharge is more expensive to produce than indicated.

Using activity-based costing, TechGadget identifies the following activity pools and their associated costs and cost drivers for a quarter:

Step 1: Calculate Cost Driver Rates

• Machine Setups: $20,000 / 200 setups = $100 per setup
• Quality Inspection: $30,000 / 1,500 inspections = $20 per inspection
• Order Processing: $10,000 / 1,000 orders = $10 per order

Step 2: Allocate Costs to Products

For the quarter, StandardCharge had 50 setups, 1,200 inspections, and 800 orders. AeroCharge had 150 setups, 300 inspections, and 200 orders.

StandardCharge Allocation:

• Machine Setups: 50 setups * $100/setup = $5,000
• Quality Inspection: 1,200 inspections * $20/inspection = $24,000
• Order Processing: 800 orders * $10/order = $8,000
• Total Allocated Overhead for StandardCharge = $5,000 + $24,000 + $8,000 = $37,000

AeroCharge Allocation:

• Machine Setups: 150 setups * $100/setup = $15,000
• Quality Inspection: 300 inspections * $20/inspection = $6,000
• Order Processing: 200 orders * $10/order = $2,000
• Total Allocated Overhead for AeroCharge = $15,000 + $6,000 + $2,000 = $23,000

This example shows that while StandardCharge is high-volume, AeroCharge, despite its lower volume, incurs a significant portion of setup costs due to its specialized nature. This insight allows TechGadget Inc. to adjust pricing or explore ways to reduce setup times for AeroCharge, leading to more accurate product costing.

Practical Applications

Activity-based costing finds diverse applications across various industries where understanding granular cost structures is critical for competitive advantage. In manufacturing, ABC helps companies accurately price custom orders or identify which products are truly profitable by tracing specific manufacturing costs like machine setups, quality control, and engineering support to individual product lines. For service-based businesses, such as a law firm or a consulting agency, ABC can allocate costs related to client acquisition, case management, or project support to specific clients or service offerings, revealing true client profitability analysis.

In the construction industry, ABC can be particularly beneficial for contractors to determine the actual cost of each project by capturing all associated expenditures, including labor, equipment, materials, subcontractors, and depreciation, eliminating broad overhead classifications.¹⁵ This allows construction firms to identify why some jobs might exceed budget or take more time, enabling improved strategic planning and more accurate bidding.¹⁴ Beyond internal analysis, activity-based costing also provides valuable information that can inform external financial reporting and help managers develop successful business strategies.¹³

Limitations and Criticisms

Despite its advantages in providing more accurate cost information, activity-based costing has several limitations and criticisms. One significant drawback is its complexity and resource intensity. Implementing and maintaining an ABC system can be time-consuming and costly, requiring substantial effort to identify numerous activities, define cost pools, and track appropriate cost drivers.¹¹, ¹² This complexity can make it less suitable for smaller businesses with simpler cost structures or limited resources.⁹, ¹⁰

Another challenge lies in the subjectivity inherent in activity allocation. Assigning costs to specific activities and choosing the most appropriate cost drivers can involve judgment, potentially leading to variations in cost allocation.⁷, ⁸ Data collection can also be a significant hurdle, as obtaining accurate and consistent data on activity usage across different departments can be difficult.⁶

Furthermore, ABC primarily focuses on variable costs and direct costs, sometimes neglecting the impact of fixed costs, which can be substantial in certain industries.⁵ There can also be resistance to change within an organization during implementation, as ABC often requires a shift in how employees and management perceive and manage costs.³, ⁴ Studies have shown that lack of knowledge about ABC, high labor input during implementation, and lack of support from management can hinder its adoption.² While ABC is powerful for internal cost management, it may not always align seamlessly with external financial reporting requirements or regulatory standards.¹

Activity-based Costing vs. Traditional Costing

The primary difference between activity-based costing and traditional costing lies in how they handle the allocation of overhead costs.

Traditional Costing typically uses a single, volume-based allocation base, such as direct labor hours, machine hours, or direct material costs, to spread overhead across all products or services. This method assumes that overhead costs are directly proportional to the chosen volume measure. While simpler to implement, it often leads to distorted product costs, especially in companies with diverse products that consume indirect resources differently. High-volume products might be overcosted, while low-volume or complex products might be undercosted, as it fails to capture the nuances of activities beyond production volume.

Activity-based Costing (ABC), in contrast, recognizes that overhead costs are driven by various activities, not just production volume. It establishes multiple cost pools for different activities (e.g., machine setups, quality inspections, engineering support) and allocates costs based on specific cost drivers related to those activities. This provides a more accurate and granular view of how indirect costs are consumed by individual products or services. Confusion often arises because traditional costing is simpler and has historically been sufficient for many businesses. However, as business processes become more complex and indirect costs grow, traditional methods can obscure true product profitability, making ABC a more insightful alternative for strategic decision-making.

FAQs

What types of businesses benefit most from activity-based costing?

Businesses that have a high proportion of indirect costs relative to direct costs, produce a wide variety of products or services, or have complex production processes often benefit most from activity-based costing. This includes manufacturing companies with diverse product lines, service industries with varied client needs, and organizations seeking to improve profitability analysis and strategic pricing.

Is activity-based costing difficult to implement?

Implementing activity-based costing can be challenging due to its complexity and the extensive data collection required. It involves identifying all significant activities, grouping them into cost pools, and determining appropriate cost drivers. This process can be time-consuming and may require significant organizational resources and training. However, the insights gained often outweigh the implementation effort for many companies.

Can activity-based costing replace traditional accounting systems?

No, activity-based costing is generally considered a complementary system rather than a replacement for traditional accounting systems. While ABC provides more accurate cost information for internal cost management and decision-making, traditional costing methods are typically still used for external financial reporting and compliance with generally accepted accounting principles (GAAP) or International Financial Reporting Standards (IFRS).

How does activity-based costing help with pricing decisions?

Activity-based costing provides a more accurate understanding of the true cost of producing each product or delivering each service. By knowing the real costs, businesses can set more competitive and profitable prices, avoid underpricing complex items, or identify opportunities to reduce costs for over-priced items. This detailed product costing insight is crucial for effective pricing strategies.