Activity Based Costing – Ultimate Guide (Part -1)

Activity Based Costing (ABC) is the division of total production process into activities and then assigning the costs on those products based on the rate of production use of these activities into making the product. Among the top companies that have been using the ABC analysis includes the American Express, Dell and Coca-cola. Such companies focus on activities as the fundamental object costs. These companies™ traces direct materials and labor to the cost object. Companies using’ Activity Based Costing will notice the difference as compared to the use of traditional method in that the traditional way puts effort in allocating indirect costs, for example manufacturing overheads, to the customers, products or services that cause such costs.

This is done through estimation of indirect cost on each activity, allocating the indirect costs based on the causes.

Development of Activity Based Costing System

Activity Based Costing occurs in the following steps:

  1. Identifying each activity
  2. Estimate the total indirect cost for each activity
  3. Establish the allocation base for each activity™s™ indirect cost (usually the cost driver)
  4. Estimate the totals quantity for each of the allocation base
  5. Calculate each activity™s cost allocation rate
  6. Rate of cost calculation for activity= Estimated total indirect cost of the activity / Estimated total quality of allocation base
  7. Obtain actual quantity of each base of allocation used by the cost objective
  8. Allocate indirect costs to the cost objective

Allocated activity cost=cost allocation rate for each activity X actual quantity of cost allocation used by cost objective

In this part, we shall have an in-depth of the first three stages of the Activity Based Costing development.

The first stage of ABC is finding out key activities that utilizes resources, which gives rise to overheads. These key activities include planning, purchasing, marketing, quality and testing, maintenance among other broad headings.

Specific jobs that need to be carried out on daily or weekly basis may need to be defined in full details. For example, in a Purchasing department, there may be several activities being undertaken by different staff members; sending out orders, checking of delivery notes, receiving of quotations, may also be measured.

Observation, conducting of interviews, reviewing job specifications and distribution of questionnaires to the workers can help in identifying specific tasks/undertakings.

The second stage is the measuring of costs. Once key activities have been identified, the next step would be to measure the costs associated to the specific activities. This information is mostly within the company™s system of accounting.

The accounting systems, nevertheless, are designed to show departmental costs rather than activities within the respective departments. If that™s the case, the accounts system may need to be redesigned, to provide costs for specific activities and tasks.

The third stage is identifying the cost driver these are wide range of factors, among them inflation. Cost driver is a term reserved to describe factors reflecting the work volume carried out in a given department or activity. These cost drivers should be accurate and in addition easy to measure.

Measuring the number of transactions undertaken is a common drive on cost e.g. number of delivery, notes, invoices, cheque and orders.

Some of the questions that would help in identifying the cost drives include;

  • What are the services provided by the activity?
  • Who are the recipients of the services?
  • What determines the staff number for the activity?
  • What types of events necessitate overtime
  • Are there cases when the activity accommodates idle periods?

In most cases, more than one cost driver is available. In this situation, the one having more direct casual relationship with the work level should be preferred for selection. Cost drivers in at this stage are also known as activity cost drivers. The drivers are classified into 3 as discussed below.

Types of activity cost drivers

  • Transaction drivers
  • Duration drivers
  • Intensity drivers

Transaction drivers

These includes the number of invoices, delivery notes, checks etc. the transaction drivers are least expensive compared to cost drivers, but also likely to be less accurate because they assume the same amount of resources is required each time an activity is performed.

Nevertheless, if the difference in amount of resources required by each cost object is not a great transaction driver will give reasonably accurate measurements of activity and the resources consumed. If the condition doesn™t apply, duration cost should then be used.

Duration drivers

These represent the amount of time required for an activity to be performed. Examples of duration drivers include inspection hours and set-up hours. For example, if now product needs a shot set-up time while another one require long time, then using set-up time as cost drivers would be more accurate as compared to the use of transaction drivers which assume that equal activity resources are consumed by both parties.

Intensity drivers

The drivers™ accounts for the resources used each time an activity is performed. Whereas the duration drivers establishes average hourly rates for an activity performance, intensity drivers are used In direct charging based on the actual resources committed to the product.

For example, if there are activities that require both skilled and unskilled personnel, a duration driver would be opted to provide the rate of hours for the projects while intensity driver would be used to record estimated or actual time for each type of personnel and assign specific resources directly to the products.

Differences between Traditional and Activity Based Costing System

Traditional costing system

  1. Low level of competition
  2. Non-volume related costs that are low proportion of the total indirect costs
  3. Fairly standardized product range, all consuming organization resources in a similar way
  4. The system allocates indirect costs to the cost centers (normally the departments)
  5. The costing is unable to calculate time cost of products since it uses overhead pool that arbitrary calculated as expenses e.g. salary

Activity Based Costing System

  1. Intensive competition
  2. Non-volume related costs that are high proportion of total indirect cost
  3. A diverse range of products, all consuming resources in different proportions
  4. The system allocates indirect costs to cost centers based on activities rather than departments
  5. Is more accurate and preferred to calculate the cost of product since the method is more cost assigning

Pros and Cons of Activity Based Costing System


  1. Activity Based Costing recognizes the fact that overheads are caused by activities; not products
  2. The system is more accurate on product costs
  3. The Activity Based costing provides a base for sub-contracting and outsourcing decisions
  4. Provides useful non-financial information and ratio
  5. Can be easily implemented by each department
  6. Can help in reducing overheads through identifying causes and responsibility for cost


  • Time consuming
  • Expensive
  • Complex
  • Creates attention away from quality of the finished products
  • It™s often impossible to choose the best cost driver

Activity Based Costing system should only be used where the cost drivers and activities have clearly been illustrated. Alternatively, Activity Based Costing can be used to reduce cost or money value rather than being used for costing products.







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