Activity based costing (ABC)

Definition and Explanation

An activity based costing system is a two-stage procedure for assigning overhead costs to products, which focuses on the major activities performed in the production process.

Activity Based Costing (ABC) is a systematic, cause & effect method of assigning the cost of activities to products, services. customers or any cost object. ABC is based on the principle that “products consume activities”. Traditional cost systems allocate costs based on direct labor. material cost. revenue or other simplistic methods. As a result, traditional systems tend to over-cost high volume products, services and customers and under-cost low volume.

The basic distinction between traditional cost accounting and ABC is as follows:

Traditional cost accounting techniques allocate costs to products based on attributes of a single unit. Typical attributes include the number of direct labor hours required to manufacture a unit, purchase cost of merchandise resold or the number of days occupied. Allocations, therefore, vary directly with the ‘volume of units produced, cost of merchandise sold or days occupied by the customer.

In contrast, ABC systems focus on activities required to produce each product or provide each service based on each product’s or service’s consumption of the activities. Using ABC, overhead costs are traced to products and services by identifying the resources, activities and their costs and quantities to produce output. A unit or output (a driver) is used to calculate the cost of each activity consumed during any given period of time.

An ABC system can be viewed in two different ways. The cost assignment view provides information about resources, activities and cost objects. The process view provides operational (often non-financial) information about cost drivers, activities and performance.

Activity Based Costing requires accountants to follow five steps.

  1. Identify the activities that consume resources.
  2. Assign costs to activities.
  3. Identify the cost driver associated with each activity. A cost driver is a factor that causes, or “drives” an activity’s cost.
  4. Compute a cost rate per cost driver unit.
  5. Assign costs to products by multiplying the cost driver rate times the volume of cost drivers consumed by the product.
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