Order Management System (OMS)

What Is Activity-Based Costing? Example And Formula

Ngoc Lee
What Is Activity-Based Costing? Example And Formula
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Businesses are shifting from standard costing to activity-based costing (ABC) due to dissatisfaction with arbitrary allocations. Amid intense competition and shrinking margins, ABC offers a structured approach to assess expenses linked to specific activities. This method enhances cost analysis, aiding more informed decisions and efficient profitability management. To get understand deeply about it, just read through this article right now!

What is activity-based costing
 What is activity-based costing

Activity-Based Costing (ABC) Definition

Activity-based costing or ABC is a way of allocating overhead expenses more precisely by attributing them to activities. Once costs have been given to activities, they may be assigned to cost objects that utilize those activities. The technology may be used to reduce overhead expenses in a targeted manner. 

In a simpler explained way, activity-based costing is described as dividing production into basic activities, defining costs for those activities, and allocating those costs to products depending on the utilization of the activities. ABC works best in complicated environments with many equipment and goods, as well as tangled processes that are difficult to sort out. 

It is less useful in a streamlined setting when manufacturing procedures are shortened and expenses are easily assigned.

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Activity-based costing definition
Activity-based costing definition

The Ways The Activity-Based Costing (ABC) Functions

Activity-based costing is commonly used in the manufacturing business because it improves the dependability of cost data, resulting in almost accurate prices and better categorizing of the expenses incurred by the business during the manufacturing process.

ABC is often used in the manufacturing industry
ABC is often used in the manufacturing industry

Target costing, product line profitability analysis, service pricing, product costing, and customer profitability analysis all employ this costing approach. The ABC is used to gain a better understanding of expenses, allowing businesses to develop a more suitable pricing approach. The cost pool total divided by the cost driver provides the cost driver rate in ABC. In activity-based costing, the cost driver is used to calculate the amount of overhead and indirect costs associated with a certain activity. 

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The ABC formula is as follows:

  • Determine all of the operations necessary to produce the product.
  • Divide the activities into cost pools that comprise all of the specific expenses associated with a particular activity, like manufacturing. Determine the total overhead for each cost pool.
  • Set cost drivers, including hours or units, to every cost pool activity.
  • To compute the cost driver rate, simply divide overhead in every cost pool by the total cost drivers.
  • Divide the number overhead of every cost pool by the total cost drivers to have the cost driver rate.
  • Multiply the cost driver rate by the number of cost drivers to get the cost driver rate.

Activity-Based Costing (ABC) Criteria

Requirement for ABC
Requirement for ABC

The ABC cost accounting method mainly depends on activities, which can be any events, units of work or tasks having a particular aim, like putting up manufacturing machines, creating items, delivering completed goods, or running equipment. Activities are considered cost objects because they use overhead resources.

An activity may be defined as any transaction or occurrence that is a cost driver in the activity-based costing system. An allocation basis is referred to as a cost driver, sometimes known as an activity driver. Machine setups, used electricity, quality check, maintenance requests, purchase orders, and production orders are all examples of cost drivers. 

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There are two types of activity measures: transaction drivers, which count how often an activity happens, and duration drivers which count how long it takes to perform an activity. Unlike traditional cost assessment methods that use ts, like machine hours, or direct labor hours, to assign indirect or overhead costs to goods, the ABC approach identifies five broad categories of activity that are, to some degree, unconnected to the number of units produced. These are examples of unit-level activity, organization-sustaining activity, batch-level activity, customer-level activity, and product-level activity.

Which Advantages That Activity-Based Costing (ABC) Can Bring To Us?

While an ABC system provides precise production cost information, it is challenging to install. That is why you should weigh the benefits and drawbacks before choosing if it is appropriate for your company.

Advantages of ABC
Advantages of ABC


When making your annual budget, you undoubtedly attempt to be as clear as possible about your incoming and departing funds. ABC can assist you in developing an accurate budget that details where your money is going and which goods are the most lucrative.

Determining Overhead 

The activity-based costing approach demonstrates how you employ overhead expenses, which assists you in determining if particular tasks are required for production.

Overhead decisions
Overhead decisions

 It also assists you in determining where you are squandering money. If you discover that some things are costing you more than they should, you can find alternative ways to conduct them. You can even eliminate stages and even goods completely.

Product Pricing

Pricing items might be one of the most challenging commercial decisions to make. Failure to evaluate all of your costs may result in you setting your rates too low. Therefore, you may not have a good profit margin.

Product pricing
Product pricing

You may allocate costs to each action in the manufacturing process using an ABC system. This displays all of the costs associated with creating a certain product. You may use this information to determine pricing that more properly reflects the cost of producing the goods.

Learn About Activity Costs

ABC is meant to track the cost of activities, allowing you to determine whether or not activity costs are in accordance with industry norms. If not, ABC is a great feedback mechanism for determining the ongoing costs of individual services while management works on cost reduction.

Identify Profitable Customers

Though the majority of the expenditures expended for individual consumers are just product prices, there is an overhead component as well, like extremely high customer service levels, cooperative marketing partnerships, and product return handling. 

An activity-based costing system may help you go through these extra expenditures and decide which clients are genuinely giving you a decent profit. This examination may lead to the rejection of certain unprofitable clients or to go a greater emphasis on those clients who provide the most income for the business.

Identifying profitable customers
Identifying profitable customers

Calculate Cost Of Distribution Channels

A typical corporation sells its products through a range of distribution channels, including retail, the Internet, wholesalers, and mail order catalogs. The majority of the structural cost of holding a distribution channel is overhead, therefore, if you can determine which distribution channels are utilizing overhead, you may make decisions to change how distribution channels are being used, or even delete unproductive channels.

Decide When To Outsource

ABC gives a thorough perspective of every expense related to in-house product manufacturing, allowing you to determine exactly which costs will be avoided if an item is outsourced versus which costs will remain.

Calculate Product Margins

You may evaluate the margins of various goods, product lines, and whole subsidiaries with optimal overhead allocation from an activity-based costing system. This may be quite helpful in choosing where to deploy firm resources in order to generate the highest profits.

Calculating product margins
Calculating product margins

Set Minimum Price Points

The price of the product is truly determined by what people are willing to pay, but the marketer should be aware of the product’s cost in order to prevent selling things that will lose the firm’s money on each sale. Activity-based costing is excellent at calculating which overhead expenses should be included in this minimal cost, due to the circumstances within which items are sold.

Determine Facility Production Costs

It is typically relatively simple to classify overhead expenses at the plant-wide level, allowing you to compare manufacturing costs between various facilities. This may result in the reallocation of manufacturing activity to facilities with reduced overhead costs, as well as the closure of abnormally high-cost facilities.

Determine facility production costs
 Determine facility production costs

Identify Costs Of Low-Volume Products

Low-volume products typically have a significant amount of overhead and other startup costs. These extra expenses are not recorded in a traditional costing system but are assigned to items in an activity-based costing system. 

Therefore, the increasing costs of low-volume items are better understood. This might result in increased prices for these items, their abolition, or a greater emphasis on lowering their related overhead and other startup expenses.

Procedure Of Activity-Based Costing

The easiest way to understand activity-based costing is to walk through its numerous processes. They are listed below.

Steps of activity-based costing
Steps of activity-based costing

Step 1: Determine Costs

The first stage in activity-based costing is to determine the expenses we wish to distribute. This is the most important phase in the process because we do not want to squander time with an overly broad project scope. 

For instance, if we wish to calculate the total cost of a distribution channel, we will determine advertising and warehousing expenses associated with that channel but will exclude research expenditures because they are associated with products rather than channels. 

In general, the scope of an activity-based costing project should be kept relatively restricted in order to make the project more manageable and cost-effective. 

Identifying costs
Identifying costs


Step 2: Add Secondary Cost Pools

Instead of directly supporting a firm’s goods or services, create cost pools for expenditures expanded to provide services to other portions of the organization. 

Secondary cost pools often comprise computer services, administrative wages, and other related expenditures. These expenditures are eventually allocated to other cost pools that have a more direct relationship with products and services. 

Depending on the circumstances of the expenses and how they will be assigned, there may be multiple of these secondary cost pools. It can aid in avoiding a large number of cost pools, hence reducing the activity-based costing system’s complexity.

Step 3: Add Primary Cost Pools

Establish a number of cost pools for costs that are more closely related to the production of commodities. Because expenses tend to arise at this level, it is highly typical to establish different cost pools for each line of products. These expenses might include R&D, advertisement, procurement, and distribution. 

Alternatively, you may explore establishing cost pools for each distribution channel or facility. If your manufacturing batches vary substantially in length, consider defining cost pools at the batch level so that you may apportion expenses appropriately depending on batch size.

Step 4: Determine Activity Drivers

Use an information management system to gather information on the activity drivers that are used to shift costs from secondary cost pools to primary cost pools and from primary cost pools to cost objects. Accumulating activity driver information can be costly, therefore, choosing activity drivers for which information is already being gathered wherever possible. If you have a selection of activity drivers, choose the one with the lowest related data gathering cost. 

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Step 5: Transfer Costs In Secondary Pools To Primary Pools

Utilize activity drivers to allocate expenditures from secondary cost pools to major cost pools.

Step 6: Attach Items With Costs

To assign the contents of each major cost pool to cost objects, you need to use an activity driver. Each expense pool will have its own activity driver. To get the cost per unit of activity, simply divide the cost in each cost pool by the total amount of activity in the activity driver. The cost per unit is then assigned to the cost objects depending on their utilization of the activity driver. 

Charge costs to cost object
Charge costs to cost object

Step 7: Create Reports

Change the activity-based system’s outcomes into reports for management consumption. For instance, if the system was initially intended to collect overhead information by geographical sales location, then report on revenues made in each area, all direct expenditures, and the overhead produced from the activity-based costing system. 

This provides management with a complete cost picture of the outcomes provided by each location, as well as the sources of the profits made by the area. 

Formulate reports
Formulate reports

Step 8: Take Action Based On The Information

When presented with an ABC report, the most typical management approach is to limit the number of activity drivers utilized by each cost object. As a result, the quantity of overhead consumed should be reduced. Furthermore, it might be beneficial for the manager to monitor management’s activities in response to ABC reports. 

If management is no longer working, it may be essential to close down the activity-based costing reporting system. Thus, the firm incurs a reporting expense while receiving no advantage from any steps to improve operations.

Activity-Based Costing Calculation

Activity-based costing formula
Activity-based costing formula

Activity Based Costing Formula = Cost Pool Total / Cost Driver 

The activity-based costing formula may be described using the basic principles listed below.

  • Cost pool: It is an item for which cost estimation is required, such as a product.
  • Cost driver: It is a factor that affects the cost of the action. Cost drivers are classified into two types: The first type is the resource cost driver which counts the number of resources consumed by an operation. It will be used to allocate a resource’s cost to an activity. For example, electricity, employee salary, advertising, and so on. The second one is the activity cost driver which is a measure of the strength of demand and the regularity with which the cost pools place activities. It will allocate the costs of the activity to a product or a customer. Material ordering expenses, inspection and testing fees, material handling and storage fees, machine setup costs, and so forth.

Examples of Activity-Based Costing

To better grasp it, let’s look at some easy to sophisticated instances.

Example Number 1

Yellow Star Ltd is contemplating switching from the old costing approach to the BC-based costing technique, and the following information is available. Determine the new overhead rates for the firm using the ABC costing method.

ActivityBudget CostCost DriverCost
Machine Set-up500000No of machine setups300
Inspection150000Inspection hours8000

Given example data of example 1

There are two activities planned. The first one is a machine setup operation, while the second one is an inspection activity. As the number of machine setups rises in the driver’s regions, so does the cost, and therefore, as the number of inspecting hours increases, so does the inspection cost. As a result, we must allocate those expenses depending on their cost drivers. We will use this formula: 

Cost pool total / Cost Driver

ABC formula
ABC formula

Then we can calculate the machine setup cost by:

Machine Setup Cost / Number Of Machine Setups = 200,000 / 300 = 666,67 

Machine setup cost
Machine setup cost

 We can also calculate the inspection cost by: 

Inspection Cost / Inspection Hours = 150,000 / 8000 = 18,75

Inspection cost
Inspection cost

Example Number 2

The following information relates to LK Ltd’s various operations and their associated expenditures. You must compute the overhead rate for each task.

Activity Cost PoolEstimated OverheadCost DriverExpected Activity
Purchasing200,000Number of purchases orders90110200
Production steps300,500Number of setups60250310
Inspection150,000Inspection hours4006001000
Assembling70,000Assembly hours9009001800
Machine maintenance500,000Machine hours6000400010000

Given example data of example 2 

Using this activity-based costing method, we have: 

Cost pool total / Cost driver

ABC formula
ABC formula

To arrive at varied rates, the overall cost of each activity pool is split by its cost driver. Based on the above formula, we can then calculate the overhead rate for the purchasing activity by: 

Purchasing / Total number of purchase orders = 200,000 / 200 = 1,000

Overhead rate for the purchasing activity
Overhead rate for the purchasing activity

Similarly, we can use the formula to calculate all the cost pool activities, and we will have the following results: Overhead Rate Of:

  • Production Steps = 300,500 / 310 = 969.35
  • Inspection = 150,000 / 1,000 = 150
  • Assembling = 70,000 / 1,900 = 36.84
  • Machine Maintaince = 500,000 / 10,000 = 50
overhead rate of
overhead rate of

 Then the total estimated overhead will be: 

200,000 + 300,500 + 150,000 + 70,000 + 500,000 = 1,220,500

Total estimated overhead
Total estimated overhead

Example Number 3

Beauty Inc., which is a cosmeceuticals manufacturing firm is thinking about transitioning from its old cost approach to a newly established system by their production head. It is activity-based costing in order for the two products, AHA serum and BHA serum, to be marketed at a fair price and remain competitive in the market.

Activity Cost PoolEstimated OverheadCost driverExpected activity
 AHA  serumBHA serumTotal
Purchasing80,000Number of purchases orders5006001,000
Material handling95,000Number of purchase receipts6001,0001,600
Production steps110,000Number of setups4008001,200
Inspection60,000Inspection hours2,0003,0005,000
Assembling30,000Assembly hours5,0005,00010,000
Machine maintenance200,000Machine hours30,00030,00060,000

Given example data of example 3

You must calculate a product-based total by using the activity-based costing formula. Applying the ABC method to the example, we have: 

Cost pool total / Cost driver

ABC formula
ABC formula

To arrive at varied rates, the overall cost of each activity pool is split by its cost driver. We have the overhead rate for the purchasing activity: 

Purchasing Activity = 80,000 / 1,000 = 80

Overhead rate for the purchasing activity for example 3
Overhead rate for the purchasing activity for example 3

We then continue to calculate the ABC cost formula for all cost pool activities in the same way.

  • Material Handling = 95,000 / 1,600 = 59.375
  • Production Steps = 110,000 /1,200 = 91.67
  • Inspection = 60,000 / 5,000 = 12
  • Assembling = 30,000 / 10,000 = 3
  • Machine Maintenance = 200,000 / 60,000 = 3.33
Overhead rates for other activities
Overhead rates for other activities

 We will have the total estimated overhead: 

Total Estimated Overhead = 80,000 + 95,000 + 110,000 + 60,000 + 30,000 + 200,000 = 575,000

Total estimated overhead for example 3
Total estimated overhead for example 3

After arriving at various rates, we must now calculate the overall cost of the product at the product level. All you need to do is just multiply the various overhead rates determined above by their actual cost drivers. We will have the following calculation: 

(AHA serum x overhead rate) + (BHA serum x overhead rate)

Overall cost of product
 Overall cost of product

Here is the result:

 AHA serumBHA serumOverhead RateAHA serumBHA serumTotal
Material Handling6001,00059.37535,62559,37595,000
Production Steps40080091.6736,66873,336110,004
Machine Maintenance30,00030,0003.3399,90099,900199,800

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The advantages of activity-based costing are particularly visible when cost accounting information is difficult to interpret owing to the existence of several product lines, machines utilized to produce different goods, numerous machine settings, and etc. 

You can understand as it is likely to use in complicated production environments. If a corporation does not function in such an environment, it may invest much in an ABC system only to discover that the associated data is not particularly useful. 

Hope you have a good time with Efex.

Ngoc LeeNgoc Lee is an Content Creator Manager at EFEX. She wields her long-term expertise in Logistics and Supply Chain, harnessing her top-notch writing and research skills to bring incredibly valuable content. Whether you're a small startup or a well-established enterprise, Ngoc Lee is here to equip you with the essential knowledge of e-commerce, fulfillment, and all things business-related.