A Step-by-Step Activity Based Costing Example
Learn how Activity-Based Costing allocates overhead to specific activities, providing a more accurate view of true product costs and business profitability.
Activity-Based Costing (ABC) is an accounting method used to assign indirect costs, or overhead, to the products or services that consume them. This approach links costs to the specific activities required for production rather than spreading them evenly. To illustrate, consider Fine Furniture Inc., a company that manufactures a high-volume “Standard Chair” and a low-volume “Custom Chair.” The company has total annual manufacturing overhead costs of $500,000.
Baseline Traditional Costing Example
Under a traditional costing system, Fine Furniture Inc. allocates its $500,000 of overhead using a single rate based on direct labor hours. The company forecasts 25,000 direct labor hours for the year, resulting in an overhead rate of $20 per direct labor hour ($500,000 / 25,000 hours).
This rate is then applied to each product. The Standard Chair requires 4 direct labor hours, resulting in an overhead allocation of $80 per chair (4 hours x $20/hour). The more complex Custom Chair requires 6 direct labor hours, leading to an overhead allocation of $120 per chair (6 hours x $20/hour).
Identifying Activities and Assigning Costs to Pools
The first step in Activity-Based Costing is to shift from a single overhead pool to multiple, distinct activities that drive costs. Fine Furniture Inc. identifies four primary activities and distributes its $500,000 in overhead among these new cost pools based on resource consumption.
Machine Setup, which involves preparing equipment for different production runs, is allocated $100,000. The hands-on Assembly process is assigned $225,000, Quality Inspection accounts for $125,000, and the Shipping activity is allocated the remaining $50,000. This segregation is the foundation for a more accurate allocation because it recognizes that different products will not utilize these activities uniformly.
Calculating the Activity Based Costs
With costs assigned to activity pools, the next stage is to calculate specific rates for each activity. This requires identifying a cost driver for each pool—a measurable factor that determines the cost of the activity.
- For Machine Setup, the driver is the number of setups. With 200 setups anticipated, the rate is $500 per setup ($100,000 / 200 setups).
- For Assembly, the driver is the number of parts. With 75,000 parts expected, the rate is $3 per part ($225,000 / 75,000 parts).
- For Quality Inspection, the driver is the number of inspections. With 1,000 inspections planned, the rate is $125 per inspection ($125,000 / 1,000 inspections).
- For Shipping, the driver is the number of orders. With 500 orders anticipated, the rate is $100 per order ($50,000 / 500 orders).
These rates are now applied to the Standard and Custom chairs based on their actual consumption of each activity. The Standard Chair, produced in larger batches, uses 50 setups, 60,000 parts, 200 inspections, and 400 orders, resulting in a total overhead of $209,000. In contrast, the Custom Chair requires more frequent setups for smaller batches, consuming 150 setups, 15,000 parts, 800 inspections, and 100 orders, which totals $230,000 in overhead.
Analyzing the Final Product Costs
Comparing the outcomes from both methods shows different product costs. The traditional method allocated $80 in overhead to each Standard Chair and $120 to each Custom Chair. The ABC method shows the Standard Chair is less expensive than initially thought, while the Custom Chair is more expensive to produce.
| Product | Traditional Overhead Cost/Unit | ABC Overhead Cost/Unit |
| :— | :— | :— |
| Standard Chair | $80.00 | $52.25 |
| Custom Chair | $120.00 | $460.00 |
The difference is due to how each product consumes activities. The Custom Chair requires a disproportionately high number of machine setups and quality inspections for its low production volume. The traditional method obscured this by spreading these costs based only on labor hours. ABC assigns the high cost of these activities to the products that demand them, providing a more accurate financial picture for strategic decisions like pricing and product management.