activity based costing

Product pricing is really based on the price that the market will bear, but the marketing manager should know what the cost of the product is, in order to avoid selling a product that will lose a company money on every sale. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold. By definition, the allocation of

indirect costs is at least somewhat arbitrary. Nevertheless,

accountants have discovered that they can improve the ways costs

are assigned, such as to movies in this case, by using

activity-based costing. In addition to estimating more accurately the true cost of production, ABC will also give a better indication of where cost savings can be made.

activity based costing

Activity based costing recognizes that the special engineering, special testing, machine setups, and others are activities that cause costs—they cause the company to consume resources. Under ABC, the company will calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. In our example, Product 124 will be assigned some of the company’s costs of special engineering, special testing, and machine setup. Other products that use any of these activities will also be assigned some of their costs.

Traditional Absorption Costing

Activity cost centres are, sometimes, similar to cost centres used under traditional costing system. In case the purchase department and purchasing activity both are treated as cost centres, the support activity cost centre also becomes identical to cost centre taken under traditional costing system. Identification of cost during activities and their causes not only help in computation of more accurate cost of a product or a job but also eliminate non-value added activities. The elimination of non-value added activities would drive down the cost of the product. In order to overcome the problems faced in traditional approach of overhead distribution, a new and more scientific approach was developed by Cooper and Kalpan known as Accounting Basics for Entrepreneurs Entrepreneurship. The ABC aims to identify the activities which results in currency of the cost.

Let’s start uncovering the magic of the activity-based costing process. This innovative method offers a more accurate and detailed understanding of how you’re using resources and racking up costs. Getting into the weeds can make it difficult to track data without an elaborate (and tried and true) system. Not to mention, some businesses don’t have the job positions and resources to manage an ABC system. Read on to learn the basics of what activity-based costing is, how to find it, and how it can help your business. When a company asks its employees to report on the time spent on various activities, they have a strong tendency to make sure that the reported amounts equal 100% of their time.

Activity-Based Costing Process

Activity based costing System has developed basically on account of the limitations of the traditional absorption costing system. Allocations, therefore, vary directly with the ‘volume of units produced, cost of merchandise sold or days occupied by the customer. An activity is an event, task or unit of work with a specified purpose e.g., designing products, setting up machines, operating machines and distributing products. Activity-based costing incorporates in its costing system the basic and vital role of different activities. ABC System refined costing system by focusing on individual activities as the fundamental cost objects. By giving a detailed breakdown of costs and the activities that drive them, the accounting system can help you make more informed decisions about pricing, production, and process improvements.

Since it is a customized order, Platinum will be billed at cost plus 25%. Using the ABC allocation rate formula, you can now allocate this amount to the final cost of producing the product. That means that if your clerk worked for 500 hours to fulfill orders for this product, the overhead cost would be $11,665. It would also include the number of parts or materials that are purchased. Remember that any of the activities you identify will need to have a cost assigned.

Step 2. Load Secondary Cost Pools

The fundamental advantage of using an ABC system is to more precisely determine how overhead is used. Once you have an ABC system, you can obtain better information about the issues noted below. Working on the principle that large cost savings are likely to be found in large cost elements, management’s attention will start to focus on how this cost could be reduced. Take your learning and productivity to the next level with our Premium Templates. Access and download collection of free Templates to help power your productivity and performance.

activity based costing

It can also be used for customers’ profitability analysis which can help in identifying the customers who are more profitable and hence to be focused more. Transaction drivers include number of transaction which results in overhead costs e.g., inspections performed, setups undertaken, number of purchase orders etc. It increases the number of cost pools used to accumulate overhead costs. Thus, instead of accumulating overhead costs-in a single company- wise pool or departmental pools, the costs are accumulated by activities. CIMA defines ABC as, “Cost attribution to cost units on the basis of benefit received from indirect activities”. It can also be defined as “the collection of financial and operational performance information tracing the significant activities of the firm to product costs”.


Therefore, there is no reason to assign any cost in an arbitrary manner. In some cases finding the activity that causes the cost is impractical. For example, factory insurances, factory manager’s salary, rent, rates and taxes of the factory premises. In these cases, it is better to allocate costs on the basis of arbitrary volume. (v) Accuracy in Product Cost – ABC system ascertains accurate product cost due to better understanding of the cost behaviour.

activity based costing