Activity-Based Costing (ABC)

Activity-based costing (ABC), volume-based traditional costing; job costing, process costing; actual costing,
normal costing, standard costing; steps of ABC; advantages and disadvantages of ABC

Cost accumulation methods represent methods used to accrue costs. There are two types: job costing
and process costing. These methods depend on the type of production.

Job costing is a product costing system when costs are accumulated by specific job orders (e.g.
Job Order XX2, Job Order 02357) and assigned to batches of products. In other words, manufacturing
costs are assigned to specific jobs: specific customers, specific orders, specific projects, specific
contracts, etc. Job costing is often used by small and medium-sized firms. Also, it is often used in the
following industries: professional services (e.g. medical, legal), advertising agencies, construction,
shipbuilding, custom equipment/furniture manufacturing, etc.

Process costing is a product costing system when costs are accumulated by departments or
processes (e.g. Printing Department, Assembling Department) and assigned to a large number of
homogenous, identical products. In other words, manufacturing costs are assigned to each process in
each manufacturing department: assembling costs (including direct materials, direct labor, and factory
overhead) in the assembling department; cost of printing (direct labor, direct materials, and factory
overhead) in the printing department, etc. Process costing is usually used by companies characterized
by continuous mass production (i.e. firms that produce one or a few homogenous products). Process
costing is often used in the following industries: textiles, food processing, automobile manufacturing,
electronics, drugs, paper, paint, oil refining, chemicals, service companies offering homogenous
services, etc.

Cost measurement methods represent methods used to measure and record the cost of direct materials,
direct labor, and factory overhead. There are three methods: actual costing, normal costing, and standard
costing.

Actual costing is a product costing system when a company measures actual costs of direct
materials, direct labor, and factory overhead. Actual costing system is rarely used because it does not
provide accurate information on a timely basis: many costs can be measured only at the end of the
production, and some actual costs fluctuate a lot leading to potential errors in price recording.

Normal costing is a product costing system when a company measures the actual costs of direct
materials and direct labor, but uses predetermined factory overhead rates to measure the factory
overhead cost for a period. In other words, throughout the production time, the company measures and
records the actual costs of direct materials and direct labor used, but it estimates a portion of factory
overhead to be assigned to the product(s) (i.e. factory overhead applied). Normal costing system
provides a timely cost estimate of a product or batch of products.

Standard costing is a product costing system when a company measures all costs direct
materials, direct labor, and factory overhead using standard quantities and costs. It is often used to
measure performance, determine target costs, and improve production process.

Overhead assignment methods represent methods used to collect and allocate factory overhead costs.
These methods depend on a type of cost drivers that a company uses to allocate factory overhead costs to
products or batches of products.

Volume-based costing, also called traditional costing, is a product costing system when a
company allocates factory overhead costs to a single cost pool (e.g. factory overhead) and then uses
volume-based cost drivers to allocate factory overhead costs to individual products or services. The
company uses volume-based cost drivers that depend on number of units manufactured. Cost bases
(or drivers) often used are: labor hours, machine hours, labor costs, etc.

Activity-based costing (ABC) is a product costing system when a company allocates factory
overhead costs to activity centers (e.g. machine set ups, running machines) and then uses activity cost
drivers to allocate factory overhead costs to individual products or services.

An activity cost driver is a quantity of activities needed to produce a product (e.g. machine set
ups activity center will have set-up hours as the activity cost driver).

The activity cost driver rate is calculated by dividing activity expenses by the total quantity of the
activity cost driver (e.g. machine set up expenses divided by total number of machine set up hours).

An easy way to remember the relationship between products, activity cost drivers, and resources, is to recall
that products consume activities and activities consume resources.
Now, when we have covered the various costing methods used to collect, measure, and allocate
manufacturing costs, we can discuss in greater detail the costing methods used to allocate factory overhead
costs.

2. Volume-based versus activity-based costing (ABC)

Many companies, especially small and medium-sized businesses, use the traditional volume-based
costing system to allocate factory overhead costs to individual products or services. Volume-based costing
system is simple and easy to use and understand, and it does not cause much product cost distortions if a
company produces goods with very similar production volumes and batch sizes, or in other words, the
company uses simple production. When using volume-based costing system, a company determines factory
overhead rates for the entire production (i.e. plant-wide rate) or for each department separately (i.e.
department-rate). Single plant-wide and multiple production department rate methods are shown in the
illustration below.
Illustration 1: Overhead rates in volume-based costing

Volume-based costing system can be also used by companies that manufacture products or offer services
that require a small amount of factory overhead costs or use the same amount of activity. However, such
companies should also have stable technology and similar distribution systems for their products or
services. Overall, when factory overhead costs have a high correlation with direct labor-costs, traditional
costing system can be a relatively appropriate system to use.
Even though traditional costing system can be used relatively effectively in some cases, it has many
limitations. Because volume-based costing uses an aggregate rate rather than a specific one, it loses a lot of

information and control over product costs. A selected volume-based cost driver (e.g. direct labor-hours)
might have little to do with how factory overhead costs accumulate. This can cause not only product price
distortions, but it can also decrease the incentives for department managers to control product costs.
On the other hand, an activity-based costing (ABC) system is a complex cost system that provides
detailed and accurate information about each products cost and thus each products profitability. The ABC
system is very expensive and time-consuming system to implement due to the high cost of collecting,
measuring, and recording production information, especially for companies that produce many different
products that require hundreds of various activities. For a large company, it might take millions of dollars and
many years to develop and implement an ABC system. Despite its high cost, ABC systems have many
benefits to offer.

Activity-Based Costing (ABC)

2.1. The advantages of an activity-based costing system
An activity-based costing system has the following advantages:

Accurate product cost and product and customer profitability measurement: An ABC system
provides accurate and detailed product information that can be utilized by management in decisionmaking process. It can help to make better-informed management decisions concerning product
pricing, product volumes, market segments, product lines, and target costing.

Better-informed strategic decisions: The information about cost drivers for each activity enables
management to make better-informed decisions concerning product design, customer support, etc.

Production improvement: An ABC system provides information helpful in improving production

processes.

Better product cost information: An ABC system provides a lot of information necessary for
strategic budgeting, planning, and product pricing decisions. It also takes into consideration cost of
unused capacity and measures it at all levels (i.e. product, batch, and facility-levels).

In activity-based costing:

Both manufacturing and nonmanufacturing (period) costs could be allocated

to products.

Some manufacturing costs that are not related to product costs can be excluded from product
costs.

Activity cost drivers (or overhead rates) can be based on the level of activity at the factorys
capacity rather than on the budgeted level of production. In other words, products are not assigned the
cost of idle capacity, which results in a more stable unit cost. Idle capacity costs, in this case, are
treated as period costs (i.e. an expense on income statement) and thus are not buried in inventory
costs (i.e. cost of goods sold).

There are multiple specific cost drivers that are more accurate than a single plant-wide rate or
multiple department overhead rates, which are used in volume-based costing (see illustration below).

Illustration 2: Overhead rates in activity-based costing

Though an ABC system has many benefits and advantages, it fails to properly include all product-related
costs and fails to allocate the cost activities with ambiguous cost drivers. Many general costs, such as
marketing, research and development, and engineering, are not included into an ABC system since they are
classified as period costs (i.e. not product costs) according to GAAP (generally accepted accounting
principles). For some activities, also, it is either impossible or unreasonable to try to identify a cost driver,
and it is often better to use a volume-based cost system in that case. For example, it is better to allocate
factory property taxes (i.e. factory overhead) using a volume-based cost driver (e.g. square-footage). The
same will be true for a factorys manager salary, factory insurance, etc.
Now, when we have compared volume-based and activity-based costing and have determined the benefits
of ABC, we can examine three steps in developing an ABC system.

Activity-Based Costing (ABC)

3. Development of an activity-based system
There are three steps necessary to develop an ABC system. The steps are the following:
1.

Identifying available resources and resource-consuming activities

2.

Assigning costs of available resources to activities

3.

Assigning costs of activities to cost objects (i.e. products, batches of products)

Let us review each of these steps in greater detail.

3.1. Identifying available resources and resource-consuming activities

At first, a company developing an ABC system has to identify the resources
consumed by the company and their cost. Note that a resource is an economic good consumed in
performing activities. For example, Friends Company, a manufacturer of valves, has the following resources:
manufacturing equipment, supplies, utilities, wages, office expenses, furniture, etc.
In addition to identifying available resources, the company has to determine the activities that consume
the companys resources, or in other words, resource-consumption cost drivers. Resource-consumption
cost drivers can be divided into two categories: Transaction drivers and Duration drivers.
Transaction drivers count the number of times an activity occurs (e.g. number of orders processed,
number of orders shipped, number of items inspected). Transaction drivers can accurately measure the
activity rate when the activity requires the same amount of time. For example, the amount of bills processed
would be an accurate activity measure when it takes the same amount of time to process each bill. However,
a more accurate type of activity measure is a duration driver.

Duration drivers measure the time required to perform an activity. For example, duration drivers measure
the amount of time required to inspect items, to process bills, to process orders, etc. Duration drivers are
more accurate measurement of the consumption of resources.
To determine resource-consumption cost drivers, the company collects data concerning the activities
performed in a manufacturing process. Such information can be gathered from the companys records and
documents as well as from observations, interviews of personnel, and surveys. Some of the questions often
asked are: What activities do you do? What resources are necessary to perform these activities? How much
time do you spend performing these activities?
Besides collecting data regarding activities, the company ranks activities according to their level of resource
consumption.
Activity levels of resource consumption:
A unit-level activity is an activity performed on each individual product or service. At this level, the cost
drivers will be volume-based since the amount of activity will proportionally depend on the number of units
produced. For example, for Friends Company, a manufacturer of valves, the unit-level activities include
inserting piston into piston valves, inspecting each unit, and providing power to run processing equipment.
A batch-level activity is an activity performed on each batch of products or services regardless of how
many units are in the batch. For instance, the cost of setting up equipment is the same whether the batch
has ten or thousand units. Examples of batch-level activities are: placing purchase orders, setting up
machines (i.e. per batch and not per individual product), conducting inspections by batch, arranging for
deliveries to customers, etc. At this level, examples of cost drivers are: orders processed, number (or
duration) of set-ups, number of inspections, etc.
A product-level activity (also called, a product- or service-sustaining activity) is an activity performed to
support production of a specific product or service regardless of how many batches are run or how many
items are produced. Examples of product-level activities are: purchasing product parts, designing, modifying
(re-engineering) and testing products, managing inventory, advertising a product, maintaining a product
manager, etc. At the product-level, examples of cost drivers are: number of categories of product parts,
design and testing time, number of engineering orders, number of inventory categories, etc.
A customer-level activity is an activity that relates to specific customers, not specific products. Examples of
customer-level activities are: IT-support, sales calls, sales visits, catalog mailings, etc. We will talk in greater
detail about customer-level costs when we will learn about customer cost and customer profitability
analyses.
A facility-level activity (also called, a business/organization sustaining activity) is an activity that supports
business operations in general and cannot be traced to individual units, batches, or products. Examples of
facility-level activities are: managing factory, heating factory, providing factory safety and security,
maintaining general-purpose equipment, cleaning executive offices, arranging for loans, closing books each
month, preparing annual reports to shareholders, providing a computer network, etc.
Note, that the activities can be traced in the ascending order and not vice versa. For example, a unit-level
activity can be traced to a batch-level activity, and a batch-level activity can be traced to a product level
activity, but not vice versa. In addition, within each group of activities, the activity cost centers that use the
same cost driver are combined into homogeneous cost pools (e.g. Customer Orders, Customer relations).

Activity-Based Costing (ABC)

3.2. Assigning cost of resources to activities
Then, once the company has identified its available resources and resourceconsuming activities, it will assign the cost of resources to the activities that consume those
resources. To accomplish that, the company will choose resource consumption cost drivers. For example,
for batch-level activities the resource consumption cost driver is the number of setups; for general

maintenance activities the number of square feet; for machine maintenance or repair activities the
number of machine hours; for labor-intensive activities (e.g. product testing, engineering) the number of
labor hours, etc. For instance, if a machine set-ups activity requires 0.5 machine hours, and each machine
hour costs $20, then, the machine set-ups activity costs $10 ($20 x 0.5).
The cost of resources consumed by an activity can be determined through direct tracing or estimation.
For example, Friends Company, a manufacturer of valves, can directly trace the cost of electricity consumed
by manufacturing machines by reading the power meter attached to the machines. When it is impossible to
directly trace the cost of resources to activities, a factory supervisor and department managers will estimate
the amount of effort (or time) spent by employees on performing such an activity.
By assigning cost of resources to the activities consuming those resources, a company can determine the
cost of each activity. Using this information, the company can determine the cost of the factorys output.

3.3. Assigning cost of activities to cost objects

Finally, the company will assign cost of activities to cost objects based on activity consumption cost
drivers. Examples of cost objects are: individual products or services, job orders, projects, customers,
business units, etc. Activity-consumption drivers measure amount of activity consumed by a cost object.
For example, to assign a cost of inspection activities, a number of inspection hours (or reports) consumed by
a cost object will be used as an activity-consumption driver. If an hour of inspection activities costs $15, and
a cost object consumes two hours of inspection activities, then the cost object will be allocated $30 for
inspection activities.
Using the example mentioned in an earlier section (i.e. if a machine set-ups activity requires 0.5 machine
hours, and each machine hour costs $20, then the machine set-ups activity costs $10): if a cost object
requires three machine set-ups, and the machine set-ups activity costs $10, then the cost object will be
assigned $30.
Examples of activity consumption cost drivers are: direct labor hours, machine hours, number of set-ups,
purchase orders, inspection and receiving reports, etc.
Overall, steps for implementing activity-based costing are summarized below:
Illustration 3: Steps in developing an activity-based costing (ABC) system

Activity-Based Costing (ABC)

4. Comparison illustration of volume-based and activity-based costing
To better understand the differences between the traditional and activity-based costing and how those
differences affect product profitability analysis as well as management decisions, we will look at the following
example.
Friends Company, a manufacturer of valves, produces and sells two types of valves:
Gas Safety Valves (GSV) and MSC Valves (MSC). Friends Company has the following data for the two
products:
GSV
Production Volume
Selling Price
Unit prime cost
Direct labor-hours
Direct labor-hours per unit
Budgeted factory overhead
Budgeted direct labor-hours

MSC
10,000
$78.00
$21.00
30,000

5,000
$130.00
$35.00
20,000
4

$600,000
50,000

4.1. Using a volume-based costing system in an example

Lets calculate the unit product cost using volume-based costing. Under traditional costing, the factory
overhead cost is assigned based on direct labor-hours (DLH). The factory overhead rate is determined as
follows:
Factory Overhead Rate per DLH =

Total Factory Overhead

Total DLH

In this case, the factory overhead rate per DLH = $600,000 / 50,000 = $12 per DLH (i.e. plant-wide rate).
Using this information, we can determine the total amount of factory overhead assigned to each product and
the factory overhead cost per unit for both products:
GSV
MSC
$12.00 per DLH
30,000
20,000
$360,000
$240,000
10,000
5,000
$36.00
$48.00

Factory overhead cost per DLH

Direct labor hours
Factory overhead assigned
Production volume (in units)
Factory overhead cost per unit
Note: $360,000 = $12.00 x 30,000 and $240,000 = $12.00 x 20,000.

Now we can calculate the unit margin profit for each product and determine how profitable the products are:

Unit selling price

Less: Unit prime cost
Less: Unit overhead cost
Unit margin
Unit margin percentage

A
B
C
D=A-B-C
E=D/A x 100%

Note C: $36.00 = $12.00 x 3 hrs and $48.00 = $12.00 x 4 hrs.

GSV
$78.00
($21.00)
($36.00)
$21.00
26.92%

MSC
$130.00
($35.00)
($48.00)
$47.00
36.15%

Therefore, using the volume-based costing we can see that the product MSC is much more profitable than
the product GSV. However, lets use the activity-based costing and see if we can get the same or similar
results.

Activity-Based Costing (ABC)

4.2. Using an activity-based costing (ABC) in an example
Friends Company, a manufacturer of valves, produces and sells two types of valves: Gas Safety Valves
(GSV) and MSC Valves (MSC). Friends Company has the following data for the two products:
GSV
Production Volume
Selling Price
Unit prime cost

MSC
10,000
$78.00
$21.00

5,000
$130.00
$35.00

In addition, Friends Company has identified the following activities, costs, and activity consumption
cost drivers:
Activity
Machine set-ups
Machine running
Inspection
Packing
Total

Budgeted Cost
$100,000
$400,000
$70,000
$30,000
$600,000

Cost Driver
Number of set-ups
Machine-hours
Inspection-hours
Number of packing-orders

Friends Company also collected the activity data for each product:
Cost Driver
Number of set-ups
Machine-hours
Inspection-hours
Number of packing-orders

GSV
80
18,000
3,000
2,100

MSC

Total

260
36,000
4,000
3,500

340
54,000
7,000
5,600

Using the total cost for each activity and the total amount of activity cost driver we can determine the activity
cost rate:
Cost Driver
Number of set-ups
Machine-hours
Inspection-hours
Number of packing-orders

Cost ($)
Activity Amount Activity Rate ($)
A
B
C=A/B
100,000
340
294.12
400,000
54,000
7.41
70,000
7,000
10.00
30,000
5,600
5.36

As we can see from the table above, one set-up costs $294.12, one machine-hour costs $7.41, one
inspection-hour costs $10.00, and one packing order costs $5.36. Now, lets calculate the per-unit cost of
each product manufactured by Friends Company:

Activity Cost Driver

Number of set-ups

GSV (10,000 units)

Activity Rate
Activity
Total Overhead
Amount
A
B
C=A x B
$ 294.12
80
$ 23,529.60

Overhead per
Unit
D=C/10,000
$ 2.35

Machine-hours
Inspection-hours
Number of packing-orders
Total

Activity Cost Driver

Number of set-ups
Machine-hours
Inspection-hours
Number of packing-orders
Total

7.41
10.00
5.36

18,000
3,000
2,100

133,380.00
30,000.00
11,256.00

MSC (5,000 units)

Activity Rate
Activity
Total Overhead
Amount
A
B
C=A x B
$ 294.12
260
$ 76,471.20
7.41
36,000
266,760.00
10.00
4,000
40,000.00
5.36
3,500
18,760.00

13.34
3.00
1.13
19.82

Overhead per
Unit
D=C/5,000
$ 15.29
53.35
8.00
3.75
80.39

The allocation of factory overhead using activity-based costing is summarized in the illustration below.
Illustration 4: Friends Companys allocation of factory overhead costs using ABC

Using the obtained data we can perform the product profitability analysis; that is, we will determine the unit
margin profit of each product:

Unit selling price

Less: Unit prime cost
Less: Unit overhead cost
Unit margin
Unit margin percentage

A
B
C
D=A-B-C
E=D/A x 100%

GSV
$78.00
($21.00)
($19.82)
$37.18
47.67%

MSC
$130.00
($35.00)
($80.39)
$14.61
11.24%

According to the data presented in the table above, the MSC product is actually $22.57 ($37.18 $14.61)
less profitable than the GSV product. The unit margin percentage for the MSC product is lower than the one

for the GSV product when using the activity-based costing. Therefore, the management of Friends Company
might consider changing the production process of the MSC product (e.g. increase batch-size to decrease
the cost of machine set-ups per item produced) and increasing the selling price (i.e. as long as the increase
in selling price would not substantially decrease product sales).
Using this example we can see that activity-based costing provides a lot of information about production
activities and how they affect the cost of products, which the volume-based costing system does not explain.
Lets compare the product profitability analyses under volume-based and activity-based costing:

Unit selling price

Less: Unit prime cost
Less: Unit overhead cost
Unit margin
Unit margin percentage

Volume-based Costing
GSV
MSC
$78.00
$130.00
($21.00)
($35.00)
($36.00)
($48.00)
$21.00
$47.00
26.92%
36.15%

Activity-based Costing
GSV
MSC
$78.00
$130.00
($21.00)
($35.00)
($19.82)
($80.39)
$37.18
$14.61
47.67%
11.24%

As we can see from the table above, the product per-unit cost and per-unit margin profit differ under the
volume-based and activity-based costing. The reason is that activity-based costing traces overhead
consumption by each product and thus provides a more accurate per-unit overhead cost.
On the other hand, volume-based costing assigns factory overhead costs using direct labor-hours or
machine-hours as a cost driver. As the result, volume-based costing undercosts low-volume product (i.e.
products requiring fewer direct labor hours in total) and overcosts high-volume products (i.e. products
requiring more direct labor-hours in total). In our example, the production of GSV product and MSC product
required 30,000 and 20,000 direct labor-hours, respectively. Therefore, the overhead per unit cost for
products GSV and MSC were overstated and understated, accordingly.
Using the data obtained under the activity-based costing, for example, we can see that the overhead perunit cost of product GSV is overstated by $16.18 (i.e. $16.18 = $36.00 $19.82) under the volume-based
costing because the production of GSV requires more direct labor-hours (in total). Thus, a product MSC in
this case is subsidized at the expense of others. In cost accounting this is called cross-subsidization.

Activity-Based Costing (ABC)

5. Dangers of product price distortion
Inaccurate product costing can lead to unrealistic strategic focus and pricing, ineffective management
decisions and resource allocation, inaccurate inventory valuation, and lost competitive position and
advantage.
For example, Friends Corporation may change its marketing and production priorities to sell more units of
product GSV because this product provides a better return on sales.

6. Benefits of activity-based costing

Companies likely to benefit from ABC are those with:
1.

Relatively high factory overhead costs

2.

Complex operations (i.e. products or services with various production volumes and requiring
many diverse activities)

3.

Operations that undergone significant technological changes

Even though both manufacturing and service companies can benefit from an ABC system, service
businesses might have more difficulties implementing an ABC system. First of all, service companies tend to
have a lot of facility-level activities and costs that are difficult to allocate to specific service units. In addition,
service companies employees often engage in many non-uniformal activities for which it might be
challenging to collect cost data. Nonetheless, activity-based costing has been implemented by various
banks, health care providers, and insurance companies. Examples of companies using ABC are: American
Express, Cambridge Hospital Community Health Network, the City of Indianapolis, Dana Corporation, GE
Medical Systems, Hallmark, ITT Automotive North America, Pillsbury, the U.S. Immigration and
Naturalization Service (INS) and the U.S. Postal Service.
ABC can be used not only to improve product pricing, but also to improve the value of products or services
to customers, which could help to increase the firms profitability. After developing an ABC system, a firms
management can utilize such tools as activity-based management (ABM) and customer profitability analysis
discussed in other accounting tutorials.