Definition:
Activity-based costing (ABC) is a method of allocating overhead costs to products or services based on the activities that consume those costs. It’s a more accurate approach than traditional methods, which often allocate overhead costs based on volume-based measures like direct labor hours or machine hours.
Key steps in ABC:
- Identify activities: Identify the key activities that consume overhead costs within the organization.
- Determine cost drivers: Determine the factors that cause overhead costs to change for each activity.
- Allocate overhead costs: Allocate overhead costs to activities based on the cost drivers.
- Calculate product or service costs: Calculate the total cost of products or services by adding direct materials, direct labor, and the allocated overhead costs.
Why is ABC used?
- Improved accuracy: ABC provides a more accurate allocation of overhead costs, as it considers the specific activities that consume those costs.
- Better decision-making: ABC can help businesses make better decisions about pricing, product mix, and resource allocation.
- Cost reduction: By identifying and addressing non-value-added activities, ABC can help businesses reduce costs.
Example:
In a manufacturing company, traditional costing might allocate overhead costs based on direct labor hours. ABC, on the other hand, might allocate overhead costs based on activities such as machine setup, product inspection, and material handling. This more granular approach can help identify products that are consuming more overhead costs than expected.
In essence, ABC is a more sophisticated costing method that provides a more accurate and informative view of a company’s product or service costs.
