Activity-based costing is a type of costing system that can be used to assign costs more accurately to products and departments in today's complex business world.
There are many types of costing systems available for businesses to use; most of these costing systems are designed to assign costs to products. Activity-based costing (ABC) on the other hand is designed to assign costs to activities. ABC has become popular due to the fact that as businesses grow in complexity, so does their need to assign increasingly large indirect costs to the appropriate area or activity. Computers have contributed both to the complexity of businesses and to their ability to track costs more closely through systems like activity-based costing.
What is Activity-Based Costing?
Simply put, activity-based costing is a process where costs are assigned due to the cause and effect relationship between costs and the activities that drive costs. Traditional costing systems have a tendency to assign indirect costs based on something easy to identify (such as direct labor hours). This method to assigning costs can be very inaccurate, as there is not necessarily a relationship between the costs that are being assigned, and the activity they are being assigned to. This can make evaluating costs tricky and inaccurate.
Activity-Based Costing Procedures
Activity-based costing can be more complicated to set-up and operate than other costing systems. Generally, the process will look something like this:
- All activities that use resources are identified
- Cost pools are set up for each of the activities identified
- Overhead costs are assigned to the cost pools based on a cost driver
- A cost driver is an activity that has a proven cause and effect relationship with the costs associated with the cost pool
- Cost drivers can be based off of resources or activities
- Only if a cost driver cannot be recognized will a cost be assigned on an allocative basis
- Related cost pools are assigned an overhead rate based on cost drivers
- Cost pools are used to assign costs; the basis depends on the company and industry
- Costs can then be assigned to units, batches, or products
- These pools can be combined to look at facility, division, or other levels of cost categories
- Costs can then be evaluated to see where and how costs are occurring, from that point management can discern what costs are controllable and how they arise.
When is Activity-Based Costing Appropriate?
Activity-based costing can theoretically be used in almost any industry, because it can be adapted to determine costs at so many different levels. However, ABC is used most effectively in complex companies that are not entirely service-based. Complex companies may see the most benefit from this type of costing because it is most helpful when the costing information is difficult to understand or evaluate. Service industries may not benefit as much from activity-based costing as other industries because their costs can be difficult to assign as they may not have an identifiable cause and effect relationship. Companies considering using ABC should also keep in mind that while it can be a very powerful management tool, it can be very expensive to start and it does not always conform to generally accepted accounting principles (GAAP) so if using an ABC system a company may have to keep a separate system to track costs in a manner that does conform to GAAP.
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