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.
- What is activity-based costing ABC?
- Why do companies and organizations use activity-based costing?
- How does activity-based costing compare to traditional cost accounting?
- Quantitative Example: Traditional "cost accounting" for direct and indirect costs.
- Quantitative example: Calculating direct and indirect costs with activity-based costing.
- Comparing traditional and activity-based costing: Advantages and disadvantages.
- What is activity-based management ABM?
- 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.
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%).
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 CostingManagement 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.
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|
|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.
|Prod. A & B Indirect||% of Total Indirect|
|Machine testing & calibration||$300,000||21.1%|
|Machine maintenance & cleaning||$287,000||20.2%|
|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.
|Product A||Product B||Total|
|9. Units produced and sold |
[Table 2, line 1]
|10. Total direct costs |
[Table 2, line 8]
|11. Total indirect costs |
[allocation shown above]
|12. Revenues per unit |
[Table 2, line 2 ]
|13. Direct costs/unit |
[ = 10 / 9 ]
|14. Indirect costs/unit |
[ = 11 / 9 ]
|15. Gross profit/unit |
[ = 12 − 13 − 14 ]
|16. Gross profit margin |
[ = 15 / 12 ]
| 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.