ACTIVITY-BASED COSTING (ABC)

Activity-based costing (ABC) is an accounting method that identifies the activities that a firm
performs and then assigns indirect costs to products. An activity-based costing (ABC) system
recognizes the relationship between costs, activities and products, and through this
relationship, it assigns indirect costs to products less arbitrarily than traditional methods.

Some costs are difficult to assign through this method of cost accounting. Indirect costs, such
as management and office staff salaries are sometimes difficult to assign to a particular
product produced. For this reason, this method has found its niche in the manufacturing
sector.
It involves the following steps:

Identification of activities involved in the production process;

Classification of each activity according to the cost hierarchy (i.e. into unit-level,
batch-level, product level and facility level);
Identification and accumulation of total costs of each activity;
Identification of the most appropriate cost driver for each activity;
Calculation of total units of the cost driver relevant to each activity;
Calculation of the activity rate i.e. the cost of each activity per unit of its relevant cost
driver;

Cost Hierarchy
The first step in activity-based costing involves identifying activities and classifying them
according to the cost hierarchy. Cost hierarchy is a framework that classifies activities based
the ease at which they are traceable to a product.

The levels are

(a) unit level,

(b) batch level,

(c) product level, and

(d) facility level.

Unit level activities are activities that are performed on each unit of product. Batch level
activities are activities that are performed whenever a batch of the product is produced.
Product level activities are activities that are carried out separately for each product. Facility
level activities are activities that are carried out at the plant level. The unit-level activities are
most easily traceable to products while facility-level activities are least traceable.

Implementation Steps

Step #1: Activity Identification

First, activities must be identified and grouped together in activity pools. Activity pools are
the supporting activities that tie in to a product line or service These pools or buckets may
include fractionally assigned costs of supporting activities to individual products as
appropriate during the second step.

Step #2: Activity Analysis

ABC continues with activity analysis, clearly identifying the processes which support a
product and avoiding some of the systemic inaccuracies of traditional costing. ABC costing
requires activity analysis, similar to the process mapping found in lean manufacturing.

This activity analysis identifies indirect cost relationships and allows assignment of some
percentage of that activity to an end product directly.

Step #3: Assignment of Costs

Based on the findings of step #1 and #2, costs are assigned to an activity pool. For example,
human resources costs would be assigned to indirect administrative or indirect management
costs. These pools will each have some contribution to object cost.

Step #4: Calculate Activity Rates

Initial analysis may include direct labor hours, or indirect support labor. These activities must
be assigned a value in real currency. All weightings must be added at this step. For instance,
production labor hours should be in terms of a weighted labor rate including benefit costs.
Step #5: Assign Costs to Cost Objects

Once activity costs, pools and rates are identified and clearly defined, the next step is to
assign them to cost objects. Objects are generally defined as the results offered to a customer.
In both manufacturing and non-manufacturing environments, this product should have some
saleable value to compare to the assigned costs.

Step #6: Prepare and Distribute Management Reports

Once ABC costing analysis is complete, that cost data should be placed in a concise and
coherent manner for cost object and process owners. This communication of the costing
analysis is critical to justify the cost of the analysis, as often this is not an inconsequential
cost.

Conclusion

ABC costing does nothing for the organization if the information is collected but no action
follows. The key to the value of this form of costing is that it is actionable. This analysis
allows companies to make decisions about product lines, where to direct sales efforts, and to
validate the true value provided by capital equipment.

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