What is Activity Based Costing?

Activity based costing is an accounting theory that involves assigning all the costs of the business to each individual product or service provided. This type of costing is most frequently seen in the manufacturing sector, where there are a wide range of products being created at the same time. The purpose of this type of costing is to have a method for evaluating the total cost to create and sell a specific product. Theses costs are divided into two areas: indirect and direct costs.

Indirect costs are typically considered overhead costs. The costs must be incurred for the business to run, but they do not contribute directly to the end product the business sells. Examples of indirect costs are administrative staff, accounting software, utilities, and rent.

Direct costs can be traced directly to the product being made. The amount of direct cost allocated to a specific product is based on the actual usage of that commodity. For example, in a commercial bakery, the direct costs for a line of carrot muffins include the costs of the flour, sugar and carrots. The amount of flour and sugar actually required to make the muffins is used to determine the cost allocation.

In activity based costing, the calculation of the direct costs and allocation to each different product line is a fairly simple matter. For each order that is placed for supplies, the quantity required for each product line is noted. The costs are then split, based on the actual supply request and charged to different cost centers in the accounting system.

The same process is followed for sales. All sales are recorded for each product line, and the revenue from the sales are allocated to the cost center, as a revenue item. This allows the product manager to run simple reports to determine if the product is profitable or not.

The complexity of this accounting model is related to indirect costs. The portion of overhead costs that each product should be charged can be defined based on a wide range of options. Some firms use percentages, others look at profitability, product life cycle stage, or other methods. Since the costs are indirect, there is no easy way to determine exactly what proportion of these resources are being used to support one specific product or product line. This is the purpose of activity based costing.

Initially known as cost accounting, accountants would use general percentages to allocate the overhead expenses. Under activity based costing, different measures are used to divide a large unit or resources into smaller units that can be allocated to specific tasks or products. For example, the staff costs for maintenance mechanics can be difficult to allocate, as their time is shared.

With activity based costing, the mechanic records the start and end time each time they work on a machine. The actual time spend working on the machine, together with the hourly rate for the mechanic allows the accountants to determine the machine maintenance costs for the unit. It is important to remember that the hourly rate must include the employer benefits costs, as well as paid vacations.