Activity-Based Costing
Activity-Based Costing (ABC) attempts to more accurately assign overhead costs to the users of overhead by focusing on activities. The basic principle underlying activity-based costing is that an activity, which is a task, operation, or procedure, is what causes costs to be incurred. For example, cutting raw materials consumes, labor and machine hours. Likewise, warehousing products consumes resources (costs) such as employee time for driving a forklift, the electricity to power the forklift, and the wear and tear on a forklift. Also, training employees drives costs such as fees or salaries paid to trainers and the training supplies, required. Generally, all activities of an organization can be linked to use of resources. An activity cost pool is a collection of costs that are related to the same or similar activity. Pooling costs to determine an activity overhead (pool) rate for all costs incurred by the same activity reduces the number of cost assignments required.
There are two basic stages to ABC. The first stage of ABC cost assignment is to identify the activities (cost objects) involved in manufacturing products and match those activities with the costs they cause (drive). To reduce the total number of activities ABC accumulates overhead costs into activity cost pools and then uses activity rates to allocate those costs to products. This involves 4 steps: 1) identify activities and the costs they cause; 2) group similar activities into activity cost pools; 3) determine an activity rate for each activity cost pool; and 4) allocate overhead costs to products using those activity rates.
While ABC improves the accuracy of overhead cost allocations to products, it has limitations. The major advantages of using ABC include more accurate overhead cost allocations, more effective overhead cost control, a greater focus on relevant factors, and