Activity Based Costing – Table of Contents
What is Activity Based Costing?
Activity-based costing systems (also known as ABC costing) is a type of cost allocation process where it identifies all types of company’s costs and allocates them to the costs to the products on the basis of actual consumption.
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 and similarly the number of purchase orders (i.e. PO) used to allocate the purchasing expenses of the purchasing department.
Activity Based Costing Formula
Activity Based Costing is calculated as
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 product
- Cost Driver: It is a factor that will cause a change in the cost of that activity. There are 2 kinds of cost driver:
- 1) Resource Cost Driver: It is a measure of the quantity of resources which shall be consumed by an activity. This 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 that is placed on the activities by the cost pools. It will be used to assign the activity costs to a product or a customer. E.g. Material ordering costs, Machine set up costs, Inspection and testing charges, Material handling and storing costs, etc.
Step by Step Examples of Activity Based Costing (with Excel Template)
Let’s see some simple to advanced examples of Activity Based Costing Formula to understand it better.
Activity Based Costing Example # 1
BAC ltd is considering shifting from traditional costing method to ABC based costing method and it has got the following details. Using ABC costing formula, find out the new overhead rates for the company.
Below is given data for calculation of Activity Based Costing.
We are here given two activities, first one is machine set-up activity and the second one is inspecting the same, so the drivers are as 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 increase in inspection cost as well. Hence, we need to allocate those cost based upon their cost drivers.
Using the ABC formula: Cost Pool total / Cost driver
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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
Activity Based Costing Formula Example # 2
Following details pertains to different activities and their costs for Gamma Ltd. You are required to calculate the overhead rate for each activity.
Below is given data for calculation of Activity Based Costing.
We are here given five activities hence, we need to allocate those cost based upon their cost drivers.
Using the ABC formula: Cost Pool total / Cost driver
Each activity pool 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, do the calculation of ABC Cost Formula for all the cost pool activities
Total Estimated Overhead = 862500.00
Activity Based Costing Formula Example # 3
Mamata inc. a manufacturing company of drugs is considering switching from their traditional method of cost to a newly implemented system by their production head which is activity-based costing so that the two products Z serum and W serum can be sold at their proper cost and make them price competitive in the market.
Below are the production details that have been derived from the production sheet.
You are required to arrive at product based total cost using ABC formula.
We are here given six activities hence, we need to allocate those cost based upon their cost drivers.
Using the ABC formula: Cost Pool total / Cost driver
Each activity pool 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 = 60000/1000
Activity Based Costing for Purchasing will be –
Overhead Rate for the Purchasing Activity = 60.00
Similarly, do the calculation of ABC Cost Formula for all the cost pool activities
And the total estimated overhead is 506250.00
After arriving at different rates, we now have to arrive at product level total cost which would be nothing but multiplying different overhead rates as arrived above with their individual actual cost drivers.
Relevance and Uses
Activity-based costing i.e. ABC based costing will enhance the process of costing 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 these costs in one organization-wide pool. Second, instead of on volume measures like direct labor costs 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 cost traceable to these activities.
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