What is Activity-Based Cost Accounting?

Osmand Vitez

Management accounting is an internal form of accounting found in many businesses. A significant aspect of this accounting type is allocating the costs of goods or services produced by the company. Activity-based cost accounting is a particular form of cost allocation used in companies. It focuses on allocating costs based on cost drivers, which represents an activity that will add costs to goods or services. Although somewhat detailed and time consuming, activity-based cost accounting will often provide companies with the most accurate cost for the products they produce.

In activity-based cost accounting, a driver is used to allocate overhead costs of a factory to the goods that are being produced.
In activity-based cost accounting, a driver is used to allocate overhead costs of a factory to the goods that are being produced.

Three main costs exist in a cost accounting environment: direct materials, direct labor, and manufacturing overhead. Direct materials represents any physical item needed to produce a good, such as lumber, minerals, computer chips, plastics, or other items. Direct labor is the manpower associated with producing the product. Only the labor involved with the main production process is direct labor. Manufacturing overhead is the utilities or facilities cost that is the result of the production process. Each of these groups will have a cost driver for activity-based cost accounting; this is how costs are applied to the goods and services produced.

Direct materials allocation is fairly straight forward in activity-based cost accounting. The cost of each material needed to produce a good is the cost driver. Therefore, this is the cost for this specific portion of the accounting process. It can become complicated, however, if the company has multiple direct materials needed to produce a single unit. Accountants must be sure to include each cost on the portion of materials used in the product.

Direct labor is also easy to calculate in this cost accounting method. Each hour of labor — or partial labor hour — is a cost-driving activity. This results in the production labor cost to be directly allocated to the product. Similar to the allocation of direct materials, multiple individuals who work on producing the item must have the cost allocated, or companies will under-value the product and lose money on this portion of the process.

Manufacturing overhead is where the bulk of work occurs when allocating costs in an activity-based cost accounting method. Accountants will calculate the cost it takes the company to set up the production process for a good. This is common under the batch costing method, which is one of two common cost methods in management accounting. Accountants must then determine the best cost driver in which to use when applying manufacturing overhead, such as number of labor hours or machine hours required to produce a good. The process to allocate manufacturing overhead becomes total overhead costs divided by the total hours, which will give a per-unit cost to allocate to all produced goods or services.

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