Activity-Based Costing (ABC) – Overview

  

**Activity-Based Costing (ABC) – Overview**  

**Activity-Based Costing (ABC)** is an advanced cost accounting method that assigns overhead costs based on actual activities driving costs, rather than traditional volume-based allocation (e.g., direct labor hours or machine hours). It provides more **accurate product costing** by identifying cost drivers.  

 **Industries Using ABC Costing**  

✔ **Manufacturing** (Automobile, Electronics)  

✔ **Healthcare** (Hospitals, Clinics)  

✔ **Service Industry** (Banks, Airlines)  

✔ **Retail & Logistics**  

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 **Key Steps in ABC Costing**  

**Step 1: Identify Activities**  

Break the production process into **cost-generating activities** (e.g., ordering materials, machine setup, quality inspection).  

 **Step 2: Assign Costs to Activities**  

Accumulate costs for each activity (e.g., material handling, packaging, maintenance).  

 **Step 3: Identify Cost Drivers**  

Determine what factors drive costs for each activity (e.g., number of purchase orders, machine hours, units produced).  

**Step 4: Calculate Activity Rates**  

\[

\text{Activity Rate} = \frac{\text{Total Cost of Activity}}{\text{Total Cost Driver Units}}

\]  

 **Step 5: Assign Costs to Products/Services**  

Multiply the activity rate by the cost driver usage for each product/service.  

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**Example of ABC Costing**  

A factory produces **Product A** and **Product B**. The company identifies **three main activities** and their costs:  

| Activity         | Total Cost ($) | Cost Driver      | Total Driver Units |

|-----------------|--------------|----------------|----------------|

| Machine Setup   | 10,000       | No. of Setups  | 50             |

| Material Handling | 20,000       | No. of Orders  | 100            |

| Quality Control | 15,000       | No. of Inspections | 150            |

**Step 1: Compute Activity Rates**  

\[

\text{Setup Rate} = \frac{10,000}{50} = 200 \text{ per setup}

\]

\[

\text{Handling Rate} = \frac{20,000}{100} = 200 \text{ per order}

\]

\[

\text{Inspection Rate} = \frac{15,000}{150} = 100 \text{ per inspection}

\]

**Step 2: Assign Costs to Products**  

| Product | Setups | Orders | Inspections | ABC Cost ($) |

|---------|--------|--------|------------|------------|

| A       | 20     | 40     | 60         | (20×200) + (40×200) + (60×100) = **$14,000** |

| B       | 30     | 60     | 90         | (30×200) + (60×200) + (90×100) = **$21,000** |

Total ABC Cost Allocation:  

- **Product A: $14,000**  

- **Product B: $21,000**  

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 **Advantages of ABC Costing**  

✅ **More accurate cost allocation** (avoids over/under-costing)  

✅ **Improves pricing decisions** (better cost visibility)  

✅ **Helps identify cost-saving opportunities**  

 **Limitations of ABC Costing**  

❌ **Complex & time-consuming** to implement  

❌ **Expensive** (requires software and data tracking)  

❌ **Not suitable for all businesses** (best for multi-product firms)