Activity-Based Costing (ABC): A Comprehensive Guide

Activity-based costing is a more specific way of allocating overhead costs based on “activities” that actually contribute to overhead costs. In job-order costingJob Order Costing GuideJob Order Costing is used to allocate costs based on a specific job order. This guide will provide the job order costing formula and how to calculate it. As an example, law firms or accounting firms use job order costing because every client is different and unique. Process-costing, on the other hand can be used and variance analysisVariance AnalysisVariance analysis can be summarized as an analysis of the difference between planned and actual numbers. The sum of all variances gives a, overhead costs are applied based on a specific cost driver such as labor hours or machine hours.

An activity is an event, task, or unit of work with a specific purpose, whether it be designing products, setting up machines, operating machines, or distributing products. Therefore, activity-based costing considers all the potential activities instead of relying on just one variable (either labor hours or machine hours).

Generally, activity-based costing is used in the manufacturing industry, as it produces more accurate cost data, generating values that are close to the true cost and can be identified during the production phase.

Activity-based costing serves and complements many other analyses and measures, including target costing, product costing, product line profitability analysis, service pricing, and more. Thus, it is used to better understand the company’s true costs, and thereby formulate an appropriate pricing strategy to mitigate unnecessary expenses.

Labor Hours Approach vs Activity-Based Approach

Let take a look at the following example to compare the differences:

XYZ Company manufactures and sells two types of tables: Standard and Luxury. Annual sales, direct labor hours, and total direct labor hours per year are provided below:

 TotalStandard: 2,000 units * 5 labor hours per unit10,000Luxury: 10,000 units * 4 labor hours per unit40,000Total Labor Hours50,000

Costs for materials and labor for each table are provided below:

 StandardLuxuryDirect Materials$25$17Direct Labor ($12 per hour)$60$48

Manufacturing overhead costs total $800,000 every year. The breakdown of these costs among the company’s six activity cost pools is given below. The following six activities contribute to overall overhead costs.

 Estimated MOHStandardLuxuryTotalLabor related$80,00010,00040,00050,000Machine setups$150,00030002,0005,000Parts administration$160,000503080Production orders$70,000100300400Material receipts$90,000150600750General factory machine hours$250,00012,00028,00040,000

Using the predetermined overhead rate approach with labor hours, the predetermined overhead rate is equal to $16 per labor hour ($800,000 / 50,000 labor hours). Using this information, we can design a cost card for each product.

Unit Cost Card Using Labor Approach

 StandardLuxuryDirect materials$25$17Direct labor$60$48Manufacturing overhead applied:Standard: 5 labor hours * $16 per labor hour$80Luxury: 4 labor hours * $16 per labor hour$64Unit product cost$165$129                                                                          

Activity-Based Approach to Determine Overhead

Using the activity-based costing approach, we can determine overhead rates for each activity that is relevant to production. The activities listed below are given in this example but companies usually break down the relevant activities.

ActivityEstimated MOHTotal per ActivityOverhead RateLabor related$80,00050,000 hours$1.60 per labor hourMachine setups$150,0005,000 setups$30.00 per setupParts administration$160,00080 parts$2,000 per partProduction orders$70,000400 orders$175 per orderMaterial receipts$90,000750 receipts$120 per receiptGeneral factory machine hours$250,00040,000 machine hours$6.25 per machine hour

Next, for each product, we can use the calculated overhead rates to determine the overhead numbers:

 Standard Luxury ActivityExpected ActivityOverhead appliedExpected ActivityOverhead appliedLabor-related10,000$16,00040,000$64,000Machine setups3,000$90,0002,000$60,000Part administration50$100,00030$60,000Production orders100$17,500300$52,500Material receipts150$18,000600$72,000General factory machine hours12,000$75,00028,000$175,000Total$316,500$483,500Units produced2,000Units produced10,000Overhead cost per unit$158.25Overhead cost per unit$48.35

Under the activity-based approach, the unit cost card gives different unit product costs for each product.

Unit Cost Card Using Activity-Based Approach

 StandardLuxuryDirect materials$25$17Direct labor$60$48Manufacturing overhead applied:Standard: 5 labor hours * $16 per labor hour$158.25Luxury: 4 labor hours * $16 per labor hour$48.35Unit product cost$243.25$113.35

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Benefits of Activity-Based Costing

Activity-based costing (ABC) can affect the cost distribution process in three ways:

1. The allocation of overhead costs is more accurate and precise as they are separated and grouped into pools based on the number of activities. To simplify, rather than calculating the indirect expenses of the company by pooling all costs together, ABC pools costs based on activity.
2. Activity-based costing traces previously untraceable costs, such as depreciation, to particular activities.
3. The ABC method can also change the unit cost of low-volume products by transferring overhead costs from high-volume products.

Concluding Remarks

By comparing the first unit cost card (i.e., when manufacturing overhead is applied based on just one variable: direct labor hours) and the second unit cost card (i.e., when manufacturing overhead is applied based on several important activities), we can see that the unit product cost for each product is generally similar. However, the activity-based approach is the more specific and precise way that companies will allocate their manufacturing overhead costs.

For the standard product, we can see that the manufacturing overhead cost per unit is much lower for the regular labor-based approach. In producing the product, more overhead costs were actually put into the process than estimated by the labor approach.

In contrast, for the luxury product, manufacturing overhead costs based on labor hours were higher when compared to the activity-based approach. When considering all relevant activities, overhead costs in manufacturing each product are actually less than that estimated by labor hours only.

Therefore, even though labor hours or machine hours may be a good starting point for companies to get a general idea of potential overhead costs, they can use activity-based costing as an alternative if they are looking to get a more exact assessment of overhead.

Related Readings

Thank you for reading the CFI guide to activity-based costing. To learn more about costing and accounting, see the following CFI resources:

• Fixed and Variable CostsFixed and Variable CostsCost is something that can be classified in several ways depending on its nature. One of the most popular methods is classification according
• Target CostingTarget CostingTarget costing is not just a method of costing, but rather a management technique wherein prices are determined by market conditions, taking
• Cost of Goods ManufacturedCost of Goods Manufactured (COGM)Cost of Goods Manufactured (COGM) is a term used in managerial accounting that refers to a schedule or statement that shows the total
• Cost of Goods SoldAccountingOur Accounting guides and resources are self-study guides to learn accounting and finance at your own pace. Browse hundreds of guides and resources.