Not sure what activities your overhead costs are going towards? With activity-based costing, product-focused businesses can get into the nitty-gritty details to better allocate expenses. That means you can more accurately analyze your spending—and price your products.
Activity-based costing is a complex subject. Read on to learn the basics of what activity-based costing is, how to find it, and how it can help your business.
What is activity-based costing?
Activity-based costing (ABC) is a system you can use to find production costs. It breaks down overhead costs between production-related activities. The ABC system assigns costs to each activity that goes into production, such as workers testing a product.
Manufacturing businesses with high overhead costs use activity-based costing to get a clearer picture of where money is going. Because ABC gives specific production cost breakdowns, you can see which products are actually profitable.
By using activity-based costing, you can:
- Take into consideration both the direct and overhead costs of creating each product
- Recognize that different products require different indirect expenses
- More accurately set prices
- See which overhead costs you might be able to cut back on
Activity-based costing vs. traditional costing
ABC provides an alternative to traditional costing. Traditional costing applies an average overhead rate to direct production costs based on a cost driver (e.g., hours or volume).
But, some production-related activities use more overhead expenses than others. As a result, traditional costing can give an inaccurate cost of making each product.
Traditional costing is simpler but less specific than activity-based costing. You might consider going with traditional costing if you only make a few products.
You may also use traditional costing for reporting externally (e.g., to investors) and activity-based costing for reporting internally (e.g., to managers).
Benefits and drawbacks of activity-based costing
Although an activity-based costing system gives you accurate production cost details, it can be difficult to implement. That’s why you should consider the pros and cons before deciding if it’s right for your business.
Benefits of activity-based costing
ABC costing can help with:
- Overhead decisions
- Product pricing
When creating your budget for the year, you probably try to get as specific as possible when it comes to your incoming and outgoing money.
Activity-based costing can help you to set an accurate budget that breaks down exactly where your money is going—and which products are the most profitable.
The ABC system shows you how you use overhead costs, which helps you determine whether certain activities are necessary for production.
Activity-based costing helps you identify where you’re wasting money. If you find that some activities cost more than they should, you can find new methods to do something. Or, you can cut out steps (and even products) entirely.
Another benefit of ABC is accurate product pricing. Pricing products can be one of the most difficult decisions you make in business.
Failing to take all of your costs into consideration could result in setting your prices too low. As a result, you might not wind up with a healthy profit margin.
With an ABC system, you can assign costs to each activity in the production process. This shows you all the costs that go into producing a specific product. You can use this data to set a price that more accurately accounts for how much it costs you to create the product.
Drawbacks of an ABC system
Before implementing this type of costing method, consider the cons:
- Not 100% accurate
Activity-based costing is more complicated than traditional costing. Instead of general overhead costs and production-related activities, you need to be specific.
How much time is Employee A spending on Activity XYZ? What about electricity—how should you split up utility costs by activity?
Getting into the weeds can make it difficult to track data without an elaborate (and tried and true) system. Not to mention, some businesses don’t have the job positions and resources to manage an ABC system.
Not 100% accurate
Unfortunately, there isn’t a costing method that gives you a completely accurate breakdown of your costs. So although an ABC system is more accurate and detailed than traditional costing, it isn’t 100% accurate.
For example, the ABC system requires employees to track how much time they spend on each activity (e.g., research, production, etc.). Your employees might miscalculate or even exaggerate their time spent working on an activity.
Activity-based costing calculation
Interested in using the ABC system in your business? To use this costing system, you need to understand the process of assigning costs to activities.
Take a look at an activity-based costing formula you can use:
(Overhead for Cost Pool / Cost Drivers) X Amount of Activity Cost Driver
Now, let’s take a step back and go over what exactly this means.
A cost pool is a group of individual costs associated with an activity. You can create cost pools by identifying the activities that go into creating a product. Once you’ve grouped your costs into a pool, find the total overhead. Keep in mind that there’s no set number of groups you need to have.
A cost driver is something that controls changes in the cost of an activity. Examples of cost drivers include units, labor or machine hours, and parts. Assign cost drivers (you can have more than one) to each cost pool.
When you divide the total overhead in a cost pool by your total cost drivers, you get a cost driver rate.
Here’s a breakdown of the steps that go into activity-based costing:
- Identify all the activities that go into creating a product (tip: if you spend money on it, add it in!)
- Separate each activity into groups (e.g., product line)
- Find the total overhead for each cost pool
- Assign activity cost drivers (units, hours, parts, etc. that control changes in costs) to each group
- Divide the total overhead in each group by the total activity cost drivers to get your cost driver rate
- Multiply the cost driver rate by the amount of activity cost drivers
Let’s say you allocate $10,000 in overhead to setting up 4,000 machines (your cost drivers). Your cost driver rate would be $2.50 ($10,000 / 4,000). Now, you want to know how much goes toward Product XYZ. Two hundred of the machines you set up were Product XYZ. Your overhead costs for Product XYZ were $500 ($2.50 X 200).
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This article has been updated from its original publication date of August 21, 2018.
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