How to Calculate Activity Based Costing
Learn to precisely allocate costs with Activity Based Costing. Master the essential steps for accurate financial insights and better decision-making.
Activity Based Costing (ABC) is an accounting methodology that allocates indirect costs to products and services by identifying the activities that drive those costs. This method provides a precise understanding of how resources are consumed across operations within an organization. It offers a more accurate cost picture than traditional costing systems, which often rely on broad averages. This article guides the reader through the fundamental components and systematic steps involved in calculating costs using the ABC framework.
Key Elements for Activity Based Costing
Understanding the foundational concepts of activities, cost pools, and cost drivers is necessary for Activity Based Costing. These elements form the structure for detailed allocation of indirect expenses. Proper identification and definition of each component directly influence the accuracy of the resulting cost information.
Activities represent the actions performed within an organization that consume resources. These are specific tasks undertaken in the production or delivery of goods and services. Examples include machine setup, quality inspection, order processing, and customer support. Identifying relevant activities involves analyzing operational processes to pinpoint where resources are utilized.
Cost pools are groupings of indirect costs related to a specific activity or set of similar activities. ABC collects these expenses into distinct categories. For instance, costs associated with machine maintenance, such as technician salaries, repair parts, and equipment depreciation, would be collected into a “Machine Maintenance Cost Pool.” An “Inspection Cost Pool” would accumulate all expenses related to quality checks.
Cost drivers are factors that cause a change in the cost of an activity. They serve as the basis for allocating costs from the cost pools to the products or services that consume those activities. A cost driver measures the consumption of an activity’s resources. For the “Machine Setup Cost Pool,” the number of setups might be an appropriate cost driver, while for the “Quality Inspection Cost Pool,” the number of inspections performed would be suitable.
The Calculation Process
The Activity Based Costing calculation process systematically applies the identified elements to determine the cost of products or services. This method traces costs through the activities that consume resources. The following steps outline the procedure for assigning indirect costs to cost objects.
The first step determines the total cost pool amounts. This requires summing all indirect costs assigned to each identified cost pool. For example, if a “Machine Setup Cost Pool” includes expenses for labor, supplies, and equipment depreciation related to setups, these individual costs are aggregated. If total indirect costs for machine setups amount to $50,000, this sum represents the total for that specific cost pool.
Next, the total quantity of the chosen cost driver for each cost pool must be determined over a specified period. This involves measuring the total amount of the activity that drives costs within that pool. Continuing the example, if the cost driver for machine setups is the “number of setups,” and 500 machine setups were performed, then 500 represents the total cost driver quantity.
The third step calculates the activity rate for each cost pool. This rate is derived by dividing the total cost pool amount by the total cost driver quantity. Using the previous figures, the activity rate for machine setups would be $50,000 divided by 500 setups, resulting in an activity rate of $100 per setup. This rate represents the cost incurred for each unit of the cost driver.
These activity rates are then used to allocate activity costs to individual products or services. This allocation occurs by multiplying the calculated activity rate by the amount of the cost driver consumed by each specific product or service. For instance, if Product X required 5 machine setups, it would be allocated 5 setups multiplied by the $100 per setup activity rate, totaling $500 in machine setup costs. This step ensures products are charged only for the activities they actually utilize.
Finally, to determine the total cost of a product or service using ABC, its direct costs are added to all indirect costs allocated from the various activity cost pools. Direct costs typically include direct materials and direct labor, which are directly traceable to the product. Combining these direct costs with the precisely allocated indirect costs provides a comprehensive and accurate total cost for each product or service.