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Activity-Based Costing (ABC): Meaning, Example, Features, Importance, Advantages & Disadvantages

Q: What are three advantages of activity-based costing over traditional?

The three main advantages of the ABC method are:Accurate product costingBetter understanding of cost behaviourImproved cost optimisation

By Adnan Ali

Updated on: May 2nd, 2024

5 min read

The method of determining the cost for each production activity is called Activity-based costing (ABC). Computing overhead production costs is crucial for businesses to determine accurate product pricing. While companies focus more on optimising raw material and labour costs, overhead costs are often overlooked. However, optimising overhead costs can also result in overall cost reduction. It will help companies accurately determine product pricing.

This blog explores the meaning of activity-based costing (ABC) and highlights its importance.

Objectives of Activity-Based Costing

An activity-based costing (ABC) system is useful for finding production costs. It provides granular details about overhead costs associated with each production-related activity. Knowing the exact cost of each production activity enables businesses to manage overhead costs. The core objectives of the ABC method are:

Estimating the cost of products or services accurately
Identifying value-adding and non-value-adding activities
Granular cost details are helpful for decision-making
Providing an overview of each activity for cost optimisation
Making it possible to identify non-essential activities quickly

Features of Activity-Based Costing

Activity-based costing (ABC) has the following features:

Considers direct and overhead costs of manufacturing each product
Identify indirect expenses for each product
Helps in accurate product pricing
Provides an overview of overhead costs for optimisation

Characteristics of Activity-Based Costing

Activity-based costing is a two-stage procedure. It focuses on individual activities in the production process. Organisations can use this costing method to assign costs to each activity related to their products and services.

ABC method is used to prevent over-costing and under-costing to determine accurate production costs. The systematic method assigns the cost of activities to any entity, such as products, services, or even customers.

Unlike traditional costing systems that allocate costs based on material cost, labour, or revenue, activity-based costing uses multiple parameters. Regardless of the production volume, the ABC method assigns the correct cost for each product. In this method, the activities may run across various functions, providing a more realistic picture of cost behaviour.

Despite its benefits, activity-based costing is not an alternative to process or job costing. It should be used as an integral tool to refine the existing costing system.

Activity-Based Costing Importance

While manufacturing organisations benefit more from activity-based costing, it is also suitable for service organisations. Medical care providers, government units, and financial institutions can also benefit from the ABC method.

Unit costing can be used to determine the cost of each output unit of functions necessary for service delivery using activity-based costing. There is no arbitrary allocation of indirect costs in this method.

ABC gives detailed information on how much money is spent on each activity. Thus, it offers a clear metric for improvement. Organisations can improve the cost-effectiveness and efficiency of production activities using ABC. It also provides an instant view of activities that add value to the outputs.

Managers can improve decision-making by identifying value-added activities. It also helps eliminate wasteful activities as employees can look at each activity separately.

ABC can be successful if businesses have a clear picture of all the activities. It can also help improve productivity by knowing the exact cost of each activity.

How Activity-Based Costing Works?

Activity-based costing method works based on activities, which can be tasks with specific goals, events, or other work units. Each activity could be machine calibration, product design, operation, maintenance, quality inspection, product distribution, etc.

The ABC method considers each event as a cost driver. Resources are allocated based on the cost driver requirements. Activities are broadly classified as,

Unit-level activity
Batch-level activity
Product-level activity
Organisation sustaining activity

The generic formula to compute cost based on the ABC method is:

Cost = Overhead for cost pool or cost drivers X Amount of activity cost driver

Sometimes, individual costs for one activity are grouped together as a cost pool. Cost drive primarily controls the cost changes of an activity.

Activity-Based Costing Example

For example, M/S Sharma Furniture, with a production capacity of 10 custom tables, wants to calculate the cost for each custom table. Instead of focusing on material costs and design hours, the company intends to use the ABC method to compute costs.

Design activity – Custom table requires 2 design hours at Rs 1600 per hour. The total design cost is Rs 3200
Machine setup – 2 machine setups are necessary for a custom table, and each setup costs Rs 4000. So, the total machine setup cost is Rs 8000
Material procurement cost – For custom tables, the company has to make two purchase orders with a processing cost of Rs 1000.

So, M/S Sharma Furniture uses the ABC method to compute the cost of a custom table:

Total ABC cost per table = 3200 + 8000 + 1000 = 12200

Activity-Based Costing Steps

ABC method involves the following steps:

Step 1: Identify each activity that consumes resources
Step 2: Assign an appropriate cost to each activity
Step 3: Identify cost drivers for each activity
Step 4: Calculate the cost rate per cost driver unit
Step 5: Assign product cost using cost driver rate and volume of cost drivers necessary for the product or service

Advantages and Disadvantages Of Activity-Based Costing

Activity-based costing is essential in cost optimisation. However, it is challenging to implement. Some of the advantages of ABC are:

Useful for budgeting and cost optimisation
Enables data-driven overhead decisions
Helpful for product pricing

Disadvantages of ABC are as follows:

Additional complexity compared to traditional costing
It is not 100% accurate
Needs additional data for accounting purposes

Limitations of Activity-Based Costing

While activity-based costing provides a holistic view of cost drivers for each product or service, all organisations do not widely implement it due to its limitations.

ABC method is time-consuming for large organisations because production involves numerous overhead activities.
The cost of the ABC method is vast, so only large companies with resources can afford this method.
In many cases, it is not easy to establish a cause-and-effect relationship between cost and cost drivers.

Difference between Activity-Based Costing and Traditional Costing

Features	Activity Based Costing (ABC)	Traditional Costing
Cost Allocation Basis	Allocates costs based on activities or resources consumed by each product or service.	Allocates costs based on direct labour hours, machine hours, or material costs.
Complexity	More complex as it considers multiple cost drivers and activities to allocate costs accurately.	Less complex as it relies on simple allocation bases such as labour or machine hours.
Accuracy	Generally provides more accurate product or service costs by directly tracing costs to specific activities.	This may result in distorted product costs, especially when indirect costs are allocated using only one or two cost drivers.
Cost Understanding	Offers better insight into cost behaviour and cost drivers, allowing for more informed decision-making.	Provides a basic understanding of costs but may not reflect the true cost drivers impacting operations.
Overhead Allocation	Focuses on allocating overhead costs based on activities that drive those costs, leading to more precise overhead allocation.	Often uses arbitrary overhead allocation rates, which may not reflect the actual usage of resources by different products or services.
Adaptability to Diverse Products	Suitable for businesses with diverse product lines or services as it can accurately assign costs based on activities.	May struggle to allocate costs accurately in businesses with diverse product lines due to limited allocation bases.
Cost Control and Optimisation	Facilitates better cost control and optimisation by identifying and managing activities that consume resources.	May result in inefficient cost control measures as costs are not accurately traced to the activities driving them.
Implementation Challenges	May require significant resources and time to implement due to the complexity of identifying and analysing activities and cost drivers.	Generally easier to implement as it relies on existing cost allocation methods and familiar allocation bases.
Industry Suitability	Commonly used in industries with complex production processes and multiple cost drivers, such as manufacturing and services.	Widely used across industries, particularly in traditional manufacturing where direct labour and overhead costs are significant.

Frequently Asked Questions

What is activity-based costing, and how does it work?

Under the activity-based costing (ABC) method, indirect costs are assigned to products or services based on activities necessary to produce them. It works by identifying and analysing multiple activities in the production process. It provides an accurate representation of the actual cost of a product. Under the activity-based costing (ABC) method, indirect costs are assigned to products or services based on activities necessary to produce them. It works by identifying and analysing multiple activities in the production process. It provides an accurate representation of the actual cost of a product.

What are examples of activity-based costing?

a) A manufacturing company has to deal with overhead costs related to material handling, machine setup, and quality control.

b) A service organisation must determine department-wise costs for each project based on specific requirements.

Is ABC process costing?

Activity-based costing (ABC) and process costing are different. ABC primarily focuses on indirect costs based on activities. Process costing assigns costs based on each stage of the production process.

What is a cost driver in activity-based costing?

A cost driver in ABC refers to the factor that influences the cost of an activity. For example, in a manufacturing facility, cost drivers are designing, machine setups, product inspections, labour hours, etc.

What are three advantages of activity-based costing over traditional?

The three main advantages of the ABC method are:

Accurate product costing
Better understanding of cost behaviour
Improved cost optimisation

How do you calculate the cost per unit using activity-based costing?

To calculate cost per unit, identify each activity and its cost. Determine the cost driver for each activity. Compute cost driver rate for each activity and allocate overhead costs to each product. Add direct costs and overhead costs to obtain the total cost per unit.

How did activity-based costing help manufacturing companies?

ABC method benefits manufacturing companies by providing accurate product costs, identifying process inefficiencies, and improving transparency of overhead expenses.

About the Author

Adnan Ali

Senior Content Writer

I am a curious person, and Finance is at the top of my list of interests. With more than 5 years of experience in fintech, I am an expert in lending, investment and personal finance. I believe the Devil lies in details, so I dig a lot before writing anything and armed my writing pieces with figures and facts. Read more

Quick Summary

Activity-based costing (ABC) determines production costs accurately. It assigns costs to activities, maximizing cost reduction. Its features include considering direct and overhead costs, providing accurate pricing, and assigning costs to activities. Though advantageous for cost optimization, ABC is complex and requires additional data. Implementation challenges, like time and resources, limit its use.