Activity Based Costing: Definition, Function, Components and For example

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Activity Based Costing: Definition, Function, Components and For example

Activity Based Costing Definition Function Components and For example

Ever heard Activity Based Costing? These are all transportation with pricing. Determination of product or service prices is one difficult decision that can bring your business to success or destroy business.

You have to set a good price so you can develop your company with a decent profit margin, but your price must also be competitive so that customers can enter.

Many big businesses, especially in the manufacturing sector, use the determination of activity-based Activity Based Costs to help them determine the supply price accurately. But, small businesses can also benefit from using this cost determination method.

Activity Based Costing is a complex subject. Learn the basics of activity-based cost determination, how to find it, and how it can help your business.

What is Activity Based Costing?

The Activity-Based Costing (ABC) system is an accounting method that you can use to find the total activity costs needed to create a product. ABC system set costs for each activity that goes into production, such as workers who test a product.

Many businesses use the cost of sales (COGS) to determine how much it costs to make a product. However, COGS focuses on direct costs and does not include indirect costs such as overhead costs.

Some businesses take their overhead costs and allocate them evenly among all products. But because some products use more overhead costs than others, the cost of making each product is inaccurate with this method.

By determining activity-based costs, you consider direct costs and overhead to make each product. You realize that different products require different indirect costs. By setting direct costs and overhead for each product, you can set prices more accurately. And, the activity-based cost determination process shows you which overhead costs you might reduce.

For example, you make soap. Soap A requires more additional costs, such as testing, than soap B. By using activity-based cost determination, you set the right overhead costs for the appropriate product. That way, your overhead costs are higher for soap A rather than B.

History of Activity Based Costing

To overcome the problems faced in the traditional approach of overhead distribution, a new and more scientific approach was developed by Cooper and Kalpan known as Activity Based Costing.

ABC aims to identify activities that produce cost currencies. The main focus is on the activities carried out on certain products during its production. Thus, activity is a focal point in the cost calculation.

According to Cooper and Kalpan, ABC is defined as,

“ABC system calculates the cost of individual activity and sets costs to objects such as products and services based on activities carried out to produce each product or service”.

According to Horngren,

“ABC is a system that focuses on the activities and objects of basic costs and uses this activity costs as a building block or compilation of other cost objects.”

CIMA defines ABC as,

“Attribution costs to unit costs based on benefits received from indirect activities”. Example – ordering, handling, quality assurance, etc. This can also be defined as “financial and operational performance gathering that traces the company’s significant activity to product costs”.

ABC is a special cost determination model that identifies activities in the organization and sets the cost of each activity with resources for all products and services in accordance with actual consumption by each activity.

So, in the ABC, overhead costs are attributed to the cost center or unit based on the number of activities carried out in production.

ABC is based on the cost of activity of George Staubus and input-output accounting. The ABC concept was developed in the United States manufacturing sector during the 1970s and 1980s.

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So far, Consortium for Advanced Management-International (CAM-I), provides a formative role to study and formalize the principles that are formally better known as Activity-Based Costing.

ABC lost fame in the 1990s because of alternative metrics such as Balanced Scorecard and Economic Value Added.

Activity Based Costing Function

  • To provide higher accuracy in calculating product costs and services compared to traditional cost determination systems, because all products are not evenly produced and some products are produced in large numbers and some small amounts, so the cost of production overhead has increased significantly and no longer correlates with productive machine work hours or direct working hours.
  • To understand the cost of products and customers.
  • To understand profitability based on the production or implementation process.
  • To have structured analysis with respect to complex processes.
  • To provide a lot of information to management to assist in decision making.
  • Eliminate activities that do not add value due to product diversity.
  • To increase added value activities because the diversity of customer demand is growing rapidly.

Characteristics of Activity Based Costing

  • Increase the amount of collection of costs used to accumulate overhead costs. The amount of value depends on the cost of production activities. So, instead of collecting overhead costs – in one group of companies or a collection of departments, costs are accumulated by activity.
  • It charges the overhead fees for work or different products comparable to the cost of activity in the business based on direct labor costs or direct hours or hours of machines.
  • This increases the traceability of overhead costs that produce more accurate unit cost data for management.
  • Identification of costs during activities and causes is not only helpful in calculating more accurate costs of a product or work but also eliminates non-value-added activities. Removal of non-value-added activities will reduce product costs. This, in fact, is the core of the determination of Activity Based Costing.

Components in Activity Based Costing

1. Resources (resources)

Resources is where the organization spends their money – the cost category recorded. Resources are defined as economic elements or money applied or used in implementing activities.

Salary and material, for example, is a resource used in implementing activities. Additional examples of resources include repair, inspection, rent, depreciation, utility, insurance, and inventory.

Most Activity Based Costing systems currently exclude costs such as income tax and interest expense that are not used in implementing activities.

2. Resource drivers (resource drive)

Driving resources are the basis for exploring resources to activity. Driving resources are defined as the size of the quantity of resources consumed by an activity.

Examples of resource drivers are a percentage of total square meters of space occupied by an activity. This factor is used to track a portion of the operating costs of facilities to activity.

3. Activity

Activity is a work unit. If you go to your restaurant for lunch / dinner, waiters or waiters can do the following work units:

  • Customer seat and menu offer
  • Take your order
  • Take an order to the kitchen
  • Bring food
  • Filling drinks
  • Raise and give a bill
  • Collect money and give back
  • Tackle Tables

Each is an activity and performance of each activity of spending resources that require costs

Activities represent work done in an organization. The cost of the activity is determined by exploring resources to activities using resource drivers.

4. Activities Drivers (Activity Cost Driving)

Like the drivers of resources used to track resources into activities, the activity cost drive is used to track activity costs to cost objects. Activity drivers are defined as the frequency measure and intensity of requests placed in activities by the cost object. Activity drive is used to set costs to cost objects.

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Cost drive is an activity that produces costs. Cost drive is a factor, such as activity level or volume, which causal affects costs (during a certain time range).

That is, there is a causal relationship between changes in activity level or volume and changes in the total cost of the cost object. So, the cost drivers signifies factors, strengths or events that determine the cost of activities. Based on the use of activity (consumption), activity costs are tracked to the cost object.

In the manufacturing organization, here is an example of some activity cost movers:

Some examples of activity costs:

  • The number of orders for the receiving department.
  • Purchase order quantity for the operating costs of the purchase department.
  • Shipping number for shipping department.
  • Number of units.
  • Number of settings.
  • The amount of labor costs issued.
  • Value of material in a product.
  • Number of material handling hours.
  • Number of inspections.
  • Number of schedule changes.
  • The number of parts received per month.
  • The number of hours of machines used on a product.
  • Number of hours of settings
  • Number of direct work hours.
  • The number of sub-assemblies.
  • Number of vendors.
  • Number of purchase hours and reservations.
  • Number of deleted units.
  • Number of labor transactions.
  • Customer order quantity processed
  • Number of parts
  • Number of employees.

5. Cost objects (cost object)

Objects cost, can be customers, products, services, contracts, projects, or other work units who want a separate cost measurement. The most common cost object is the cost of products or services. Activity drivers are used to track activity costs to cost objects.

Example of Activity Based Costing Case

Let’s find out how much you spend on the utility to make a product. To do this, you estimate that your total utility bill is $ 20,000 for that year.

You determine that the trigger of the cost that affects your utility bill is the number of direct work hours. The number of hours works directly works reaches 1,000 hours for that year.

Share your total utility bills with activies drivers (number of working hours) to get your cost objects rates. Your overhead application rates are $ 20 ($ 20,000 / 1,000 hours).

For this particular product, you use a utility for 3 hours. Multiply the clock with the driver rates fee $ 20 to get $ 60.


Because the determination of Activity Based Costing breaks the fees used to create products, it has many uses in business. For small businesses, cost determination based on activities is great for making overhead decisions and product prices.

With the ABC system, you can set costs for each activity in the production process, allowing you to be more accurate to set prices that take into account how much you spend to make the product.

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