What is Activity Based Costing?

Examples include square footage that is used per product, and the same would be used to allocate the rent of the factory as well as the maintenance cost of the firm; similarly, the number of purchase orders (i.e., PO) used to allocate the purchasing expenses of the purchasing department.

Activity Based Costing Formula

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The ABC formula can be explained with the following core concepts.

  • Cost Pool: This is an item for which measurement of the cost would require, e.g., a productCost Driver: It is a factor that will cause a change in the cost of that activity. There are two kinds of cost drivers:1) Resource Cost Driver: It measures the number of resources that activity consumes. It will be used to assign the cost of a resource to an activity. E.g., Electricity,  Staff wages, Advertising, etc.2) Activity Cost Driver: This is the measure of the intensity of demand and the frequency placed on the activities by the cost poolsThe Cost PoolsA cost pool is a strategy to identify the company’s individual departments or service sector costs incurred. It determines the total expenses incurred in manufacturing goods and allocates them to different departments or service sectors based on valid identifiers known as cost drivers.read more. It will assign the activity costs to a product or a customer. E.g., Material ordering costs, Machine setup costs, Inspection and testing charges, Material handling and storing costs, etc.

Examples of Activity Based Costing

Let’s see some simple to advanced examples to understand it better.

    1. Resource Cost Driver: It measures the number of resources that activity consumes. It will be used to assign the cost of a resource to an activity. E.g., Electricity,  Staff wages, Advertising, etc.2) Activity Cost Driver: This is the measure of the intensity of demand and the frequency placed on the activities by the cost poolsThe Cost PoolsA cost pool is a strategy to identify the company’s individual departments or service sector costs incurred. It determines the total expenses incurred in manufacturing goods and allocates them to different departments or service sectors based on valid identifiers known as cost drivers.read more. It will assign the activity costs to a product or a customer. E.g., Material ordering costs, Machine setup costs, Inspection and testing charges, Material handling and storing costs, etc.

Example # 1

BAC ltd is considering shifting from the traditional costing method to the ABC-based costing method, and it has the following details. Using ABC costing formula, find out the new overhead rates for the company.

We have two activities. The first one is a machine set-up activity, and the second one is inspecting the same. So the driver’s areas, the number of machine setup would increase, the cost would also increase, and similarly, as the number of inspecting hours increases, that would lead to an increase in inspection cost. Hence, we need to allocate those costs based on theirA cost driver is a unit that derives the expenses and sets a basis on which a particular cost is to be allocated between the different departments and on the basis of that driver’s activity completed in that particular period the cost is allocated. These are the structural determinants of the activities on which cost is being incurred and determine the behavior of the costs on an activity.read more cost driversCost DriversA cost driver is a unit that derives the expenses and sets a basis on which a particular cost is to be allocated between the different departments and on the basis of that driver’s activity completed in that particular period the cost is allocated. These are the structural determinants of the activities on which cost is being incurred and determine the behavior of the costs on an activity.read more.

Using the ABC formula: Cost Pool total / Cost driver

Calculation of Machine Setup Cost

Machine setup cost / Number of Machine setups

=2,00,000 / 340

Machine Setup Cost = 588.24

Calculation of Inspection Cost

Inspection cost /Inspection hours

=1,40,000 / 7500

Inspection Cost= 18.67

Example # 2

The following details pertain to different activities and their costs for Gamma Ltd. You are required to calculate the overhead rate for each activity.

Below is the given data for calculation.

We are here given five activities; hence, we need to allocate those costs based on their cost drivers.

Each activity pool’s total cost is divided by its cost driver to arrive at different rates.

Overhead Rate for the Purchasing Activity

Overhead Rate for the Purchasing Activity = 1,20,000 / 200

Activity-Based Costing for Purchasing will be –

Overhead Rate for the Purchasing Activity =600.00

Similarly, calculate the ABC Cost Formula for all the cost pool activities.

Total Estimated Overhead = 862500.00

Example # 3

Mamata Inc., a manufacturing company of drugs, is considering switching from its traditional cost method to a newly implemented system by their production head. It is activity-based costing so that the two products, Z serum, and W serum, can be sold at their reasonable cost and make them price competitive in the market.

Below are the production details that have been derived from the production sheet.

You must arrive at a product-based total cost using the ABC formula.

We are here given six activities; hence, we need to allocate those costs based on their cost drivers.

Overhead Rate for the Purchasing Activity = 60000/1000

For Purchasing, it will be –

Overhead Rate for the Purchasing Activity = 60.00

And the total estimated overhead is 506250.00

After arriving at different rates, we now have to arrive at product level total cost. It would be nothing but multiplying different overhead rates as arrived above with their actual cost drivers.

Relevance and Uses

It is a type of cost allocation processCost Allocation ProcessCost Allocation is the procedure of recognizing & assigning costs to different cost objects like a product, department, program, customer, etc., as per the cost driver serving as the base for this process. read more that identifies all kinds of company’s costs and allocates them to the costs of the products based on actual consumption.

It will enhance the process of cost in 3 different ways. First, it will expand the number of cost pools, which can later be used to assign those overhead costs. So, it pools costs by activity instead of accumulating them in one organization-wide pool. Second, instead of volume measures like direct labor costsDirect Labor CostsDirect labor costs refer to the total cost incurred by the company for paying the wages and other benefits to its employees against the task performed by them, which are straight away related to the manufacturing of the products or provision of the services.read more or machine hours, it will create new bases to assign these overhead costs to items upon these activities, which shall generate costs. Lastly, it makes the cost traceable to these activities.

This article has been a guide to Activity Based Costing (ABC) & its definition. Here we discuss the formula of activity-based costing along with its calculation & practical examples. You may learn more about excel from the following articles –

  • Standard Costing MethodsStandard Costing MethodsStandard cost is an estimated cost determined by the company for the production of the goods and services or for performing an operation under normal circumstances and are derived by the company from the historical analysis of the data or from the time and the motion studies.read moreSemi Variable CostSemi Variable CostFixed and variable costs combine to form semi-variable costs. Because semi variable costs are influenced by both fixed and variable costs, they are also referred to as mixed costs.read moreFormula of Variable CostingAbsorption CostingAbsorption CostingAbsorption costing is one of approach which is used for the purpose of valuation of inventory or calculation of the cost of the product in the company where all the expenses incurred by the company are taken into the consideration i.e., it includes all the direct and indirect expenses incurred by the company during the specific period.read morePredetermined Overhead Rate FormulaPredetermined Overhead Rate FormulaPredetermined Overhead Rate is that rate that is used to calculate an estimate on the projects which are yet to commence for overhead costs. It would involve calculating a known cost (like labor cost) and then applying an overhead rate (which was predetermined) to project an unknown cost (which is the overhead amount).read more