Activity-Based Costing

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What is Activity-Based Costing?

Activity-based costing is a more specific way of allocating overhead costs based on “activities” that actually contribute to overhead costs. In job-order costing and variance analysis, 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 (for example, 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.

Key Highlights

• Activity-based costing is a way of allocating overhead costs based on “activities.” This differentiates it from job-order costing, which allocates costs by a specific cost driver like 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.
• Activity-based costing considers all potential cost activities instead of relying on just one variable (labor hours or machine hours).

Labor Hours 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:

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

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.

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

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.

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

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

Unit Cost Card Using Activity-Based Approach

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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.

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.

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