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Activity Based Costing ABC, and ABC Management Explained
Definition, Meaning, and Example Calculations

Business Encyclopedia, ISBN 978-1-929500-10-9. Revised 2014-04-19.

Activity based costing calculations may show the  "true costs" of products, services, and projects  more accurately than traditional cost accounting

Activity based costing attempts to show the "true costs" of products, servi-
ces, and projects more accurately than traditional cost accounting.

What is activity based costing?

Activity based costing ( ABC) is a method for assigning costs to products, services, projects, tasks, or acquisitions, based on the activities that go into them and the resources consumed by these activities.

This contrasts with traditional costing (cost accounting), which sometimes assigns costs using somewhat arbitrary allocation percentages for overhead costs or the so-called indirect costs. Activity based management (ABM) is an approach to management that uses ABC for decision support and planning.

This item defines, explains, and illustrates activity based costing using example calculations to contrast ABC with traditional cost accounting, in context with related costing terms and concepts.

Contents

• Why do companies and organizations use activity based costing? 
• Examples: Activity based costing vs. traditional cost accounting 
     – Traditional costing explained with an example 
     – Activity based costing explained with an example
     – Costing methodology examples compared
• Activity based management (ABM)

Why do companies and organizations use activity based costing?

Management is moved to adopt ABC by the desire to improve costing accuracy—get closer to the true cost and true profitability—of individual products and services, or to understand better the true costs and return on investment from projects or other initiatives. ABC gets closer to true costs in these areas by turning many costs that traditional cost accounting treats as indirect costs essentially into direct costs. Examples below show how this is done.

In organizations where ABC has been implemented successfully, activity based management uses the approach to support decisions about pricing, adding or deleting items from the product portfolio, choosing between outsourcing and in-house production, and evaluating process improvement initiatives.

The percentage of organizations currently using activity based costing varies greatly from industry to industry. Various surveys in the period 2004-2013 report the highest percentage of organizations using ABC in manufacturing (20%-50%), followed by financial services (15-25%), public sector (12-18%), and communications (6-12%).

Activity based costing example vs. traditional cost accounting example 

The different approaches and the different outcomes from ABC and traditional cost accounting are easiest to illustrate in the context of a product manufacturing example. The principles shown here nevertheless extend readily to a wide range of other business environments.

For example, consider a company that manufactures automobile parts through a sequence of machine operations on metal stock. In such settings, traditional accounting views costs as either direct costs or indirect costs (or overhead).

  • Direct costs: traditionally, are those costs that can be assigned to specific product units. In product manufacturing, these might include:
    • Direct labor costs (the cost for person minutes or person hours per product unit for running production machines).
    • Direct materials (materials costs per product unit for metal stock, fasteners, lubricants, and so on). 
  • Indirect costs: traditionally, are manufacturing overhead costs that cannot be assigned directly for specific product units. Instead, these costs are allocated to specific production runs, batches, or time periods. These might include, for instance:
    • Materials purchase order costs: Materials are typically not ordered for each individual product unit, but rather, for entire batch runs or to supply materials needs for a time period.
    • Machine set up costs: Manufacturing machines are not set up for each unit, but for the production run of each product model.
    • Product packaging costs: Multiple product units may be packaged in a single package; multiple packages may be filled in a single packaging run.
    • Machine testing and calibration costs: These operations are typically performed regularly and often, but not for each individual product unit.
    • Machine maintenance and cleaning costs: These operations, too, are performed after producing multiple product units. 

The example below focuses on two product models manufactured and sold by one company, Model A and Model B. Some aspects of A and B compare as shown below in Table 1:



Products Compared Product A Product B
   Selling Price Higher price Lower price
   Materials purchased More materials purchase orders, smaller orders Fewer materials purchase orders, larger orders
   Production
   Runs
More production runs, smaller runs Fewer production runs, larger runs
  Mach.set ups More machine set ups Fewer machine set ups
  Packaging 1 Unit per package 4 Units per package
  Direct labor More direct labor required Less direct labor required
  Direct  materials Higher direct materials cost Lower direct materials cost
 Table 1.  Product A and Product B compared.

Management must estimate the profitability of each product in order to make decisions about which products to produce and sell and how to price them. This, in turn, requires an understanding of the full cost per unit of each product. While the direct costs per unit may be determined easily, the indirect costs are less obvious and will have to be found through a costing methodology—either traditional cost allocation or activity based costing. 

Direct costs will be treated in the same way under both traditional costing and ABC. For direct costs, accountants measure a cost per product unit for each direct cost category. The two costing methods differ, however, in the way they assign the so-called indirect costs to products. Thus, the two costing approaches can give different pictures of the profitability of individual products. 

     Traditional costing explained with an example 

In the previous accounting period, the company produced and sold 900,000 units of product A at $3.00 each, and 2,100,000 units of product B at $2.00 each. Table 2 below shows the resulting revenues and direct costs for these sales.

Products Compared Product A Product B Total
   1. Units produced & sold 900,000 2,100,000 3,000,000
   2. Selling price / unit $3.00 $2.00  
   3. Direct labor cost / unit $0.50 $0.50
    4. Direct materials cost / unit $0.75 $0.50
    5. Sales revenues [ = 1 * 2 ] $2,700,000 $4,200,000 $6,900,000
Direct costs  
   6. Direct labor costs [ = 1 * 3 ] $450,000 $1,050,000 $1,500,000
   7. Direct materials costs [ = 1 * 4 ] $675,000 $1,050,000 $1,725,000
    8. Total Direct costs [ = 6 + 7 ] $1,125,000 $2,100,000 $3,225,000
 Table 2. Sales revenues and direct costs for Products A and B

The company's cost accountants will also find cost totals for support activities for the entire period production of products A and B. In traditional cost accounting, these are called "overhead" or "indirect costs," which can be summarized as shown in Table 3 below: 


Indirect Components Prod. A & B Indirect % of Total Indirect
  Materials purchasing $180,000 12.6%
  Machine setups $375,000 26.4%
  Product packaging $280,000 19.7%
  Machine testing & calibration $300,000 21.1%
  Machine maintenance & cleaning $287,000 20.2%
Total Indirect      $1,422,500 100.0%
 Table 3. Indirect cost components for Traditional costing

For the simple form of traditional cost accounting illustrated here, only the total indirect cost line from Table 3 is used. Traditionally, this cost total will be allocated to each of the products, A or B, based on proportional usage of a resource, usually one of the direct cost items. This approach is also called production volume based (PVB) cost allocation, for obvious reasons. In this approach, the total indirect cost could be allocated to Products A and B based on factors such as the proportion of total

  • Production machine time used by each product.
  • Direct labor costs used by each product.
  • Factory floor space used by each product.

Other factors may also apply. For this example, company accountants chose to allocate indirect costs based on direct labor costs. The indirect cost total from Table 3 above is $1,422,500. The direct labor total (line 6 from Table 1) is $1,500,000. From these figures, indirect labor will be allocated to each product as a percentage of the product's own direct labor cost:

 Indirect labor cost / direct labor cost proportion:
        = $1,422,500 / $1,500,000 
        = 0.948 = 94.8%

  • For product A, Direct labor costs are $450,00  (Table 2, line 6). The indirect cost allocation for A is 94.8% of this, or $426,750.
  • For product B, Direct labor costs are $1,050,000  (Table 2, line 6). The indirect cost allocation for B is 94.8% of this, or $995,750.

Table 4, below, shows how this allocation is used to calculate indirect costs per unit, as well as gross profit and gross margin for each product unit.




Products Compared Product A Product B Total
  9. Units produced and 
      sold [Table 2, line 1]
900,000 2,100,000 3,000,000
  10. Total direct costs
  [Table 2, line 8] 
$1,125,000 $2,100,000 $3,225,000
  11. Total indirect costs
  [allocation shown above]
$426,750 $995,750 $1,422,500
  12. Revenues per unit
  [ Table 2, line 2 ]
$3.00 $2.00  
  13. Direct costs / unit
  [ = 10 / 9 ]
$1.25 $1.00
  14. Indirect costs / unit
  [ = 11 / 9 ]
$0.47 $0.47
  15. Gross profit / unit
   [ = 12 − 13 − 14 ]
$1.28 $0.53
  16. Gross profit margin
  [ = 15 / 12 ]
42.5% 26.3%
 Table 4. Gross profit and gross margin calculation for each product, using
 traditional cost accounting approaches for indirect costs.

Conclusions: Traditional cost allocation (or product volume based allocation) example:

  • Estimated Indirect cost per unit is the same for both products, $0.47 (Table 4, line 14). This must be the case, because indirect costs for both products use the same allocation rate ( 94.8%) applied to direct labor costs, based on the same direct labor rate ($0.50 / unit).
  • On a per unit basis, this costing approach finds Product A more profitable than product B: The gross margin rate of 42.5% for A compares with a gross margin of 26.3% for B.

     Activity based costing explained with an example

This section presents an ABC version of the product costing situation illustrated above. The example is meant to show that this method and traditional costing can lead to different cost estimates for indirect costs and thus to different profitability estimates for the same products. The example also shows clearly that this approach  requires more data and more detailed analysis than the production volume based allocation approach in the earlier example. 

ABC costing for the same product A and product B begins with the same summary of units produced and sold, sales revenues, and direct costs from the traditional example, as shown again in another copy of Table 2:

Products Compared Product A Product B Total
   1. Units produced & sold 900,000 2,100,000 3,000,000
   2. Selling price / unit $3.00 $2.00  
   3. Direct labor cost / unit $0.50 $0.50
    4. Direct materials cost / unit $0.75 $0.50
    5. Sales revenues [ = 1 * 2 ] $2,700,000 $4,200,000 $6,900,000
Direct costs  
   6. Direct labor costs [ = 1 * 3 ] $450,000 $1,050,000 $1,500,000
   7. Direct materials costs [ = 1 * 4 ] $675,000 $1,050,000 $1,725,000
    8. Total Direct costs [ = 6 + 7 ] $1,125,000 $2,100,000 $3,225,000
Table 2. Sales revenues and direct costs for Products A and B

In ABC, the "indirect" or "overhead" cost contributors are viewed as activity pools: an activity pool is the set of all activities required to complete a task, such as (process) "purchase orders" or (perform) "machine set ups."

In order to "cost"  activity pools, ABC identifies activity units that are cost drivers for each pool. The total cost of  for the activity pool "purchase orders," for instance, is driven by the number of purchase orders processed while the total cost for activity pool "machine set ups" is driven by the number of set ups. Tables 5A and 5B, below show a cost driver (CD) unit cost for each activity pool: one machine set up, for instance, is found to require $1,500 in labor, materials, energy, and other resources.

Tables 5A, moreover, shows the number of CD units (activity units) used for product A, while Table 5B shows these figures for product B. From the known cost of each CD unit, a total cost can be assigned for each product for each activity pool, as shown in the rightmost column of Tables 5A and 5B. In ABC, assigning cost totals to activity pools in this way, based on cost driver units, is called stage-1 allocation, or batch-level allocation. 

Activity Pool Cost Driver (CD)
Activity Units
CD
Unit Cost
Total Activity
Product A
Total Indir
Cost  (A)
   17. Purchase orders No of purchase orders $1,800 75 $135,000
   18. Machine set ups No of setups $1,500 150 $225,000
   19. Product 
         packaging
No of product
packages packed
$0.20 900,000 $180,000
   20. Machine testing
        & calibration
No of tests $100 1,000 $100,000
   21. Maintenance  
         & cleaning
No of batch runs $1,150 200 $230,000
                              Total $870,000
Table 5A. ABC Stage-1 allocation (batch level allocation) for product A: Activity pools, cost drivers, cost per cost driver unit, and total cost for these activities.
Activity Pool Cost Driver (CD) CD
Unit Cost
Total Activity
Product B
Total Indir
Cost  (B)
   17. Purchase orders No of purchase orders $1,800 25 $45,000
   18. Machine set ups No of setups $1,500 100 $150,000
   19. Product 
          packaging
No of product
packages packed
$0.20 500,000 $100,000
   20. Machine testing
         & calibration
No of tests $100 2,000 $200,000
   21. Maintenance  
         & cleaning
No of batch runs $1,150 50 $57,500
                                    Total   $552,500

Table 5B. ABC Stage-1 allocation (batch level allocation) for Product B: Activity pools, cost drivers, cost per cost driver unit, and total cost for these activities.

When each product's activity pool cost totals are known, the accountants can move on to calculating the cost per product unit, as shown below in Table 5C. These product unit costs are found by dividing the activity pool cost totals by the number of product units. The process of finding product unit costs is called stage-2 allocation, or product level allocation.

Activity Pool Total Indirect Cost
Product A
[From Table 5A]
Cost per product unit
Product A
Total Indirect cost Product B
[From Table 5B]
Cost per product unit
Product A
Total indirect cost
A+B
   17. Purchase orders $135,000 $0.15 $45,000 $0.02 $180,000
    18. Machine set ups $225,000 $0.25$150,000 $0.07 $150,000
   19. Product packaging $180,000 $0.20 $100,000 $0.05 $280,000
   20. Machine testing
          & calibration
$100,000 $0.11 $200,000 $0.09 $300,000
   21. Maintenance  
          & cleaning
$230,000 $0.26 $57,500 $0.03 $57,500
Total   $870,000 $0.97 $552,500 $0.26 $1,422,500
Table 5C. Stage-2 allocation in ABC: Allocating activity pool costs to individual product units. The cost per product unit figures for product A and product B (second and fourth columns) are derived from the cost sums for each activity pool (first and third columns) divided by the number of product units produced and sold for each product (Table 2, line 1).

The total product unit costs for each product correspond to the total indirect costs for each product from the traditional costing approach. Table 6 below shows how these costs contribute to the new version of profitability calculations for each product.



Products Compared Product A Product B Total
   22. Units produced and 
        sold  [Table 2, line 1]
900,000 2,100,000 3,000,000
   23. Total direct costs
   [Table 2, line 8]
$1,125,000 $2,100,000 $3,225,000
   24. Total overhead costs
  [Table 5C, line 21 ]
$870,000 $552,500 $1,422,500
   25. Revenues per unit
  [ Table 2, line 2 ]
$3.00 $2.00  
   26. Direct costs / unit
  [ = 23 / 22 ]
$1.25 $1.00
   27. Overhead costs / unit
  [ = 24 / 22 ]
$0.97 $0.26
  28. Gross profit / unit
  [ = 25 −26 − 27 ]
$0.78 $0.26
   29. Gross profit margin
   [ = 28 / 25 ]
26.1% 36.8%
Table 6. Gross profit and gross margin calculation for each product, using activity based costing for indirect, or overhead costs.

Conclusions: Activity based costing example.

  • Estimated Indirect (overhead) cost per unit is quite different for each product, unlike the traditional costing example above where indirect costs per unit were the same for both products. This approach recognizes that product A used more activity pool resources than product B.
  • On a per unit basis, the this costing approach finds product B more profitable than product A. The gross margin rate of 36.8% for B compares with a gross margin of 26.1% for A.

     What are the advantages and disadvantages of activity based costing, compared to traditional costing?

Table 7 below shows the per-unit profitability estimates for each product from the examples above.

  Product Profitability
(Gross Profit Margin)
Product A Product B
   Traditional cost allocation
   (Production volume based allocation)
42.5% 26.3%
   Activity based costing approach 26.1% 36.8%
Table 7. Comparison of profitability estimates from two different costing methods. Traditional costing shows product A more profitable than product B. ABC based costing shows the reverse. These differences result from the different treatment of overhead costs.

The tables and examples above illustrate some key differences between the costing methods:

Data and analysis

  • Activity based costing requires detailed knowledge of the activities and resources that go into overhead (or "indirect") support work.  
  •  Traditional cost accounting (production volume based allocation) requires only a total overhead cost and a simple allocation rule.

Overhead components and products: Differentiation vs. aggregation

  • ABC recognizes that individual overhead components can be distributed differently for different products. One product may consume relatively more maintenance resources, for instance, while another product may consume relatively less maintenance resources but relatively more machine set up resources.
  • Traditional cost accounting typically aggregates overhead components into fewer categories, or even a single category, and uses a single allocation rate for all products. 

Direct vs. indirect measurement

  • Activity based costing approaches overhead costs essentially as direct costs, in that cost estimates reflect actual cost driver usage for each product. These costs, in turn can be reasonably be apportioned to individual product units.
  • In traditional cost accounting (production volume based allocation), the total overhead cost is known accurately, but the distribution of that total to individual products is based on an indirect measure of that cost to different products is based on an indirect measure.

Costing accuracy vs. the cost of costing

For the profitability figures shown in Table 7 above, the activity based costing results may be taken as the more accurate results—more closely reflecting the "true" production costs of products A and B—than the profitability figures from the traditional costing approach. Whether or not the improved accuracy justifies the higher cost of applying this costing method, however, is a question management will have to investigate and answer before committing to a comprehensive new approach to costing.

Activity based management (ABM)

ABC first appeared in the mid 1980s. Since that time, the percentage of companies and other organizations using the approach has increased more or less continuously but, as mentioned earlier, nearly three decades after it first appeared, the majority of companies and organizations still do not use activity based costing, and still do not practice activity based management. 

The slow increase in adoption rates is no doubt the result of two underlying trends that advance continuously but slowly:  (1) the increasing availability and capabilities of costing implementation resources, and (2) the increasing extension of the approach into new areas of application, to address a wider range of management issues.

Regarding implementation, activity based costing requires detailed and complete information on specific activities that go into specific products, services, and tasks, as well as detailed and complete information on the resources consumed by these activities (including time, labor, and other goods and services). Implementation in large, complex organizations is thus a labor-intensive and data-intensive undertaking. Since the mid 1980s, however, ABC has  become more accessible and more affordable to many companies through

  • Recent improvements in costing software
  • The increasing availability of data from complex, comprehensive software systems, such as enterprise resource planning (ERP) systems, manufacturing resource planning (MRP) systems, and customer relationship management (CRM) systems,

When first introduced, the obvious benefits of ABC were most readily seen in product manufacturing settings, such as the one illustrated in the two numerical examples above. From the start, it was clear that in such settings, the approach was superior to traditional cost accounting for the purposes of:

  • Identifying truly profitable and truly unprofitable products.
  • Identifying and eliminating unnecessary costs.
  • Identifying and distinguishing between true value-add activities and non-value add activities.
  • Pricing products so as to achieve acceptable margins.

Increasingly, however, the value of more accurate costing has become more widely appreciated, leading to the application of this methodology for the purposes of:

  • Budgeting and financial planning: Overhead / indirect costs and funding needs may be anticipated with greater accuracy and more certainty under ABC.
  • Human capital management: human resources can be directed into more profitable, more value-added activities under this approach.
  • Performance measurement: the performance of individuals, groups, initiatives, and programs, can be evaluated with more certainty and accuracy when their true costs are better understood through ABC.

By Marty Schmidt. Copyright © 2004-

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