Activity-based costing helps you have a complete picture of how indirect costs correlate with business activities.
Whether you manufacture a product, curate your store with products made by other businesses, or sell a service, there are many costs beyond the raw materials. Think the rent for the warehouse where you store goods, the utilities that keep the office running, or the design agency you hire to create web assets for a bundle of new products.
Those expenses tack dollars onto the cost of a product or service. If your accounting doesn’t track these indirect costs, you don’t really know where your dollars are going beyond broad categories like overhead and labor, or how to consider those costs in your pricing strategy.
One way to understand those costs is through activity-based costing, an accounting technique that assigns costs based on the actions needed to deliver a product or service. Here is what you need to know about activity-based costing, and how understanding it can help you manage your company’s true costs and maintain profitability.
What is activity-based costing?
Activity-based costing, sometimes referred to as the ABC method, is an internal accounting method that allocates a business’s indirect costs based on specific activities. Indirect costs, also called overhead, encompass selling, general, and administrative (SG&A) spending. Insights about what’s driving overhead can help a business set its pricing strategy for its products and services.
Activity-based costing divides a company’s total SG&A costs into cost pools such as selling activities; general activities such as rent, utilities, and maintenance; and administrative activities such as office management, legal services, and accounting. This helps a company examine manufacturing overhead costs, as well as other types of overhead, in detail by making them traceable to particular activities and linking them to the actual costs of the production process or delivering a service.
Activity-based costing is typically used by larger companies in a manufacturing industry, but it is also used in other industries, ranging from banking and finance to health care, logistics, ecommerce, and hospitality. Although it’s not compliant with generally accepted accounting principles (GAAP) for external reporting to investors and regulatory authorities, an ABC system can help with internal profitability analysis, targeted cost reductions, and pricing strategy.
Activity-based costing vs. traditional costing
Activity-based costing is more precise than traditional methods for allocating fixed expenses and manufacturing overhead costs.
Traditional costing methods that comply with GAAP divide costs into product costs (direct expenses) and period costs (indirect expenses). Product costs are the costs incurred for materials and labor, or cost of goods sold (COGS), which are variable and directly traceable to output volume. Period costs are often fixed indirect costs, captured in SG&A, and they are incurred in a specific time period, such as a month, quarter, or year. They usually don’t change with increases or decreases in production.
Activity-based costing doesn’t make a distinction between product costs and period costs. For example, if a product requires extra support staff for processing orders, the portion of SG&A for staff support—typically a period cost—is included as part of the product cost. The rationale is that the product wouldn’t get sold if orders weren’t processed, even though the added support isn’t a direct manufacturing cost.
Another important difference between the two costing methods is how each treats unused production capacity. Traditional methods typically include unused capacity when manufacturing facilities sit idle as part of overhead, which can distort actual production costs. Activity-based costing recognizes only the cost of used capacity.
An activity-based costing system can be time-consuming and expensive to set up in parallel with an accounting system that meets GAAP standards. For companies with basic operations and few product lines, traditional and simpler costing based on distinct COGS and SG&A accounting often is sufficient. Companies with multiple product lines and complex operations may get more benefit from using both activity-based and traditional costing systems.
Activity-based costing formula
The formula for activity-based costing, also referred to as the cost-driver rate, is the total for a cost pool divided by the cost driver:
Cost pool / Cost driver = Cost-driver rate
Here is a brief explanation of the three elements in the formula:
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Cost pool. A company identifies all of the overhead activities involved in making a product or delivering a service, then it groups related activities and their associated costs, which become cost pools. For example, manufacturing overhead could be broken down into a cost pool for maintaining manufacturing equipment, one for utilities, and another for product inspection and quality control.
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Cost driver. A cost driver is what specifically causes an overhead cost. The number of quality-control (QC) checks, or the labor hours devoted to quality control, for example, could be the cost driver for QC costs.
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Cost-driver rate. The cost-driver rate is the per-unit cost of the activity in the cost pool.
Let’s say a manufacturer’s annual quality-control expense totaled $250,000, and 2,500 labor hours were logged for this activity. The cost-driver rate for quality control is $250,000 / 2,500 hours = $100 per hour.
How to use activity-based costing
- Identify activities
- Create cost pools
- Assign cost drivers
- Calculate the cost-driver rate
- Act on overhead costs
The activity-based costing process involves the following steps.
1. Identify activities
The activities involved in making a product or delivering a service include an array of business functions, such as research and development, manufacturing, sales and marketing, distribution, and customer support. Identify the activities in your business and group together similar and related activities, such as logistics and distribution, or advertising and marketing.
2. Create cost pools
Put related activities into corresponding cost pools based on their purpose. For example, a company might group overhead costs for office rent, management staff, and supplies into a cost pool, or an ecommerce business could pool purchasing and inventory management.
3. Assign cost drivers
Once you’ve sorted activities into cost pools, you can determine their total cost drivers. Cost drivers are what influence the changes in spending, like labor hours or machine hours (the hours a machine operates), units, or parts. Go through each cost pool and assign the cost drivers.
For example, a manufacturer could calculate the number of hours spent maintaining machinery. Or an ecommerce company might track logistics costs by the number of times goods move into and out of inventory.
4. Calculate the cost-driver rate
Determine the activity-based cost or cost-driver rate by dividing the expense of each cost pool by the cost drivers. For instance, a manufacturer spends $50,000 during a quarter for machinery maintenance, an overhead expense. The company’s employees log 500 hours for maintenance work in the period. The cost-driver rate is:
$50,000 / 500 hours = $100 an hour
5. Act on overhead costs
Once you calculate the activity-based cost, you have more insight into production’s overhead costs and can make informed decisions about changes to boost profitability, either through overhead cost reductions or price increases.
Activity-based costing example
Take, for example, a manufacturer of aluminum sheet metal that produces 200,000 square feet in a month. Two-thirds of production is stamped sheet for specialized uses, such as home construction trusses and brackets. The other third is plain sheet metal. Stamped sheet metal commands higher prices—about double the price of plain sheet metal—and is more profitable.
The company identifies three cost pools for activity-based costing: equipment maintenance, quality control, and factory overhead that includes rent, utilities, and supervisory staff, each calculated as an hourly indirect cost or per-activity indirect cost. These overhead costs total $500,000, including $150,000 for equipment maintenance, $100,000 for quality control inspections, and $250,000 for factory overhead—time spent by managers and office staff to oversee production.
The company then calculates the cost drivers, based on the amount of each activity during the month:
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Equipment maintenance: $150,000 / 750 labor hours = $200 per hour
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Quality control: $100,000 / 250 inspections = $400 per inspection
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Factory overhead: $250,000 / 1,000 labor hours = $250 per hour
After calculating cost drivers, the company allocates overhead costs to each type of sheet metal product. Here is how a breakdown of cost allocation might look:
For stamped sheet metal:
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Maintenance: 350 labor hours × $200 cost driver = $70,000 activity-based cost
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Quality control: 100 inspections × $400 = $40,000
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Factory overhead: 500 labor hours × $250 = $125,000
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Total cost allocation for stamped sheet metal: $235,000
For plain sheet metal:
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Maintenance: 400 labor hours × $200 = $80,000 activity-based cost
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Quality control: 150 inspections × $400 = $60,000
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Factory overhead: 500 labor hours × $250 = $125,000
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Total cost allocation for plain sheet metal: $265,000
Based on these cost allocations, the company sees that plain sheet metal, although it made up only a third of production, accounts for more than half of production overhead. After some analysis, the business might consider ways to reduce overhead costs, particularly maintenance and quality inspections for plain sheet metal. As an alternative, the business might look at increasing production of more profitable stamped sheet metal.
Activity-based costing FAQ
What is the concept of activity-based costing?
Activity-based costing is meant to provide greater insight into a business’s total overhead expense by breaking it down into discrete groups of costs associated with particular functions or activities, such as factory rent, office staff, or maintenance. The goal is to see which activities drive overhead costs the most and how to better control them.
What is an example of an activity-based cost system?
One example might be a snack-food company with 10 product lines and high overhead, with SG&A accounting for more than half of its total operating spending. Activity-based costing would help it discover which products drive SG&A expenses, which can prompt decisions about pricing and cost reductions that will determine the profitability of each product line.
What are some disadvantages of activity-based costing?
Some potential disadvantages of activity-based costing are that it doesn’t conform to GAAP accounting standards and cannot be used for external reporting. Because it isn’t GAAP-compliant, a company would have to maintain two sets of financial records, one for official reports and the other for activity-based costing. This can become cumbersome and expensive, particularly for a small business.
