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Activity-Based Costing and ABC Management
Explaining Definitions, Meaning, Example Calculations

 

Activity-based costing attempts to measure the costs of products and services more accurately than traditional cost accounting.

Companies move to Activity -Based Costing to better understand the true costs of goods and services.

What is Activity-Based Costing?

Activity-based costingABC is a method for assigning costs to products, services projects, tasks, or acquisitions, based on:

  • The activities that go into them
  • Resources consumed by these activities

ABC contrasts with traditional costing (cost accounting), which sometimes assigns costs using somewhat arbitrary allocation percentages for overhead or the so-called indirect costs. As a result, ABC and traditional cost accounting can estimate the cost of goods sold and gross margin very differently for individual products. Contradictory and uncertain cost estimates can be a problem when management needs to know exactly which products are profitable and which are selling at a loss.

What Are the Benefits of ABC?

Cost accountants know that traditional cost accounting can hide or distort information on the costs of individual products and services—especially where local cost allocation rules misrepresent actual resource usage. As a result, the move to ABC usually motivated by a desire to understand the "true costs" of individual products and services more accurately. Companies implement activity-based costing to:

  • Identify specific products that are unprofitable.
  • Improve production process efficiency.
  • Price products appropriately, with the help of accurate product cost information.
  • Reveal unnecessary costs that become targets for elimination.

Firms that use ABC consistently to pursue these objectives are practicing activity-based management ABM.

ABC Impacts the Same Accounts, But With Different Mathematics

Note that the purpose of ABC is to provide information for decision support and planning. ABC by itself usually has little or no impact on the structure of the firm's financial accounting reports (Income statement, Balance sheet, or Cash flow statement). This impact is minimal because both ABC and traditional costing ultimately assign costs to the same existing accounts. The two approaches merely use different mathematics to do so.

Note especially, however, that ABC sometimes brings improvements in reported margins and profitability. These outcomes follow when ABC reveals unnecessary or inflated costs, or when ABC shows where to adjust pricing models, workflow process, or the product mix.

Explaining Activity-Based Costing in Context

This article further defines, describes, and illustrates activity-based costing using example calculations to contrast ABC with traditional cost accounting. Examples appear in context with related terms from the fields of budgeting, cost accounting, and financial accounting.

 

Contents

Related Topics

  • For the accountant's role in assigning cost figures, see the article Accountant.
  • The article Cost Object defines and explains the term "cost object."
  • The article Direct and Indirect Labor Costs further explains the role of these terms in traditional cost accounting.
 

Why Do Companies and Organizations Move to ABC?
What are the Reasons for Using Activity-Based Costing?

Business people are moved to adopt ABC by a desire to improve costing accuracy, mainly to get closer to the actual cost and true profitability of individual products and services. And, they also move to ABC to understand better the actual costs and return on investment from projects, programs, or other initiatives. 

ABC pursues these objectives essentially by making direct costs out of many of the expenses that traditional cost accounting treats as indirect costs. Examples below show how ABC does this.

Organizations that use ABC consistently and effectively are said to practice activity-based management (ABM).Here, managers turn to ABC 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. For more on ABM, see the section below "What is activity-based management?"

The percentage of organizations currently using activity-based costing varies significantly from industry to industry. Various surveys in the period 2012-2017 report the highest rate of firms using ABC in manufacturing (20%-50%), followed by financial services (15-25%), public sector (12-18%), and communications (6-12%).

Activity-Based Costing vs. Traditional Cost Accounting
What Are the Differences? Do They Lead to Different Costing Results?

The different approaches and outcomes from ABC and traditional costing are most accessible for illustration in the context of a product manufacturing example. However, the principles appearing here extend readily to a wide range of other business settings.

Example: Traditional Cost Accounting vs. ABC

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

Example Sources of Direct Costs

Traditionally, direct costs for such firms are costs they can assign to specific product units. In product manufacturing, these might include direct materials and direct labor costs:

  • Direct labor costs.
    These can include the cost for person minutes or person-hours per product unit for running production machines.
  • Direct materials.
    Direct materials costs might include costs per product unit for metal stock, fasteners, and lubricants. 

Example Sources of Indirect Costs

Traditionally, indirect costs for such firms are manufacturing overhead expenses they cannot assign directly to specific product units. Instead, they allocate these costs to specific production runs, batches, or time periods. These might include indirect costs such as the following:

  • Materials purchase order costs
    Firms typically do not order materials for each product unit, but instead, for entire batch runs. They may also order supplies to cover a specific timespan.
  • Machine set up costs.
    Manufacturing firms do not set up production machines for each product unit. They are set up instead for the production run of each product model.
  • Product packaging costs.
    Manufacturers can sometimes package multiple product units in a single package. And, they may fill numerous packages in a single packaging run.
  • Machine testing and calibration costs.
    Manufacturing firms perform these operations regularly and often, but not for each product unit.
  • Machine maintenance and cleaning costs.
    Firms usually perform these operations only after producing multiple product units. 

Product Specific Cost Sources

For this example, consider a firm that manufactures and sells two product models, Model A and Model B. Some aspects of A and B compare as shown 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. Setups More machine setups Fewer machine setups
  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.

Direct Costs Are the Same in Traditional and Activity-Based Costing

Management must estimate the profitability of each product to decide which products to produce and sell and how to price them. These estimates, in turn, require an understanding of the full cost per unit of each product. While the direct costs per unit are easy to find, the indirect costs are less noticeable. As a result, the firm will have to uncover indirect product costs through a costing methodology—either traditional cost allocation or activity-based costing. 

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

Explaining Traditional Costing
Example Calculations and Costing Results

In one accounting period, the firm produces and sells 900,000 units of product A at $3.00 each and 2,100,000 units of product B at $2.00 each.

Traditional Costing: Finding Direct Costs

 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

Traditional Costing: Finding Indirect or Overhead Costs

The company's cost accountants will also find cost totals for the period's production support activities. In traditional cost accounting, these are called "overhead" or "indirect costs," 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

Traditional Cost Accounting: Calculating Direct and Indirect Costs

The simple form of traditional cost accounting appearing here uses only the total indirect cost line from Table 3. Traditionally, firms allocate this cost total to each product, A or B, based on proportional usage of a given resource. The resource chosen for this purpose is usually one of the direct cost items. Note especially that this approach is also called production volume based (PVB) cost allocation, for obvious reasons.

Under PVB cost allocation, accountants allocate (apportion) the total indirect cost to Products A and B based on factors such as the proportion of the 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, the firm's accountants chose to allocate indirect costs referring to 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, the firm allocates indirect labor cost 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 therefore 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 therefore 94.8% of this, or $995,750.

Traditional Costing: Allocating Indirect Costs

Table 4, below, shows how this allocation produces indirect cost estimates per unit. And, the table also shows the conventional costing solutions for 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 (Product Volume Based Allocation) Example:

  • Estimated Indirect cost per unit is the same for both products, $0.47 (Table 4, line 14). These two indirect costs must be equal because 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 traditional costing 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.

Explaining Activity-Based Costing
Example Calculations and Costing Results

This section presents an ABC version of the same product costing situation. The example shows how ABC and traditional costing can yield different indirect cost estimates for the same products. And, this means the two approaches can also estimate profitability differently. Finally, the example also shows that ABC requires more data and a more detailed analysis than the PVB allocation approach.

ABC costing for products A and B begins with the same summary table used for the traditional costing example above. Data for starting the analysis includes units produced and sold, sales revenues, and direct costs. The ABC example, therefore, begins with another copy of Table 2:

Direct Costs Under ABC

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 (second copy). Sales revenues and direct costs for Products A and B

Overhead or Indirect Costs Under Activity-Based Costing

In ABC, the "indirect" or "overhead" cost contributors are viewed as "activity pools."

Under activity-based costing, an activity pool is the set of all activities required to complete a task, such as (a) process purchase orders, or (2) perform machine setups.

To "cost"  activity pools, ABC identifies activity units that are cost driversfor each pool. The total cost of for the activity pool "process purchase orders," for instance, is driven by the number of purchase orders processed, while the total cost for activity pool "perform machine setups" is driven by the number of setups.

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.

Table 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 cost total cost can be assigned for each product for each activity pool, as the rightmost columns of Tables 5A and 5B show.  

In ABC, assigning cost totals to activity pools in this way, using cost driver units, is  stage-1 allocation or batch-level allocation

Product A activity units, activity pools, and cost drivers

     Activity Pool

Cost Driver (CD)
Activity Units
CD
Unit Cost
Total Activity
Product A
Total Indirect
Cost  (A)
17. Purchase ordersNo of purchase orders$1,80075$135,000
18. Machine setups No of setups$1,500150$225,000
19. Product packagingNo of product
packages packed
$0.20900,000$180,000
20. Machine testing
& calibration
No of tests$1001,000$100,000
21. Maintenance 
& cleaning
No of batch runs$1,150200$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 the total cost for these activities.

Product B activity units, activity pools, and cost drivers 

     Activity Pool

Cost Driver (CD)CD
Unit Cost
Total Activity
Product B
Total Indirect
Cost  (B)
17. Purchase ordersNo of purchase orders$1,80025$45,000
18. Machine setupsNo of setups$1,500100$150,000
19. Product 
packaging
No of product
packages packed
$0.20500,000$100,000
20. Machine testing
& calibration
No of tests$1002,000$200,000
21. Maintenance  
& cleaning
No of batch runs$1,15050$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 the total cost for these activities.

When each product's activity pool cost totals are known, the analysts can then calculate the cost per product unit, as Table 5C shows. To find product unit costs, the analyst divides the activity pool cost totals by the number of product units. In ABC, the process of finding product unit costs is stage-2 allocation or product level allocation.

Stage 2 allocation in ABC: Allocating activity pools to product units

     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 setups$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
Table5C. 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) derive d 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 corresponding to the total indirect costs for each product from the traditional costing approach.

Finding Overhead Costs Per Unit in ABC

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 entirely 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 uses more activity pool resources than product B.
  • On a per unit basis, ABC 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.

Comparing ABC and Traditional Costing
Advantages and Disadvantages to Each Approach

Costing Results from Two Approaches

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 allocating)
42.5% 26.3%
Activity-based costing approach 26.1% 36.8%
Table7. Comparing 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.

Key Differences Between Costing Methods

The tables and examples above illustrate some critical 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 fewer maintenance resources, but relatively more for machine set up.
  • Traditional cost accounting typically puts "overhead" components into fewer categories, or even a single class, and uses a single allocation rate for all products. 

Direct vs. indirect measurement

  • Activity-based costing treats 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), an accurate measure of total overhead cost is accessible. However, in conventional costing the distribution of that total to individual products is based on an indirect measure of that cost.

Costing Accuracy vs. the Cost of Costing

For the profitability figures appearing 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 expense of applying this costing method, however, is something management will have to investigate and answer before committing to a comprehensive new approach to cost accounting.

What is Activity Based Management?
What is the Role of ABM in Decision Making and Planning?

Note especially that the purpose of ABC is to provide management with information for decision support and planning. Organizations that use ABC consistently, to pursue costing accuracy, are practicing Activity-Based Management ABM.

Adoption of ABC and 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. However, as mentioned, nearly four decades after it first appeared, the majority of companies and organizations still do not use activity-based costing and do not practice activity-based management. 

Implementing Activity-Based Management ABM

Regarding implementation, activity-based costing requires accurate and complete information on particular activities that go into specific products, services, and tasks, as well as detailed and comprehensive information on the resources consumed by these activities(including time, labor, and other goods and services). Implementation in large, complex organizations is, therefore, a labor-intensive and data-intensive undertaking. 

Since the mid-1980s, however, ABC has become more accessible and more affordable to many companies through two ongoing trends.

  • Firstly, recent improvements in costing software.
  • Secondly, 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.

ABM Started in Manufacturing

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

  • Identifying genuinely profitable and genuinely unprofitable products
  • Finding and eliminating unnecessary expenses
  • Identifying and distinguishing between value-add activities and non-value add activities
  • Pricing products to achieve acceptable margins

Activity-Based Management: Moving beyond manufacturing

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

  • Budgeting and Financial Planning.
    Organizations can anticipate overhead costs and funding needs with higher accuracy and more certainty under ABC.
  • Human Capital Management.
    Firms can now direct human resources into more profitable activities under ABC.
  • Performance Measurement.
    Managers can evaluate the performance of individuals, groups, projects, initiatives, and programs, with more certainty and accuracy when they understand actual costs better through ABC.