Activity Based Costing Step by step

In today’s episode we’re going to discuss activity-based costing, or ABC for short.

ABC is a cost system that can be used to:
• Measure the cost of providing a good or service
• Calculate the profitability of a company’s product lines
• Perform customer profitability analysis

So why is ABC better than traditional cost systems? With traditional cost systems, you lump all the overhead costs into a single bucket and then spread them across products using a single cost driver that may not be correlated with overhead.

But with ABC you:
• Identify the activities that logically cause overhead costs to be incurred
• Group overhead costs into cost pools based on the activity type
• Calculate activity rates for each of those cost pools
• Use activity rates to assign costs to the cost object (product, department, customer, etc.)

Thus, you’re identifying all the different activities that drive overhead costs and allocating costs accordingly. Costs are allocated based on cause-on-effect relationships, instead of a single, arbitrary measure.

Activity-based costing:
• First puts the overhead into cost pools
• Then allocates overhead to the product using activity rates

This is sometimes called a two-stage allocation.

But there’s another difference between ABC and traditional cost systems that pertains to manufacturers. Both U.S. GAAP and IFRS state that inventoriable costs (aka product costs) include 3 things:
• The cost of direct materials
• The cost of direct labor
• Manufacturing overhead

But because ABC is all about finding the most accurate, most relevant cost this definition of product costs is ignored.

When a company is calculating the cost per unit with ABC it might:
• Assign some nonmanufacturing costs to the product
• Exclude some manufacturing costs from the product

Thus, a manufacturer that wants to adopt activity-based costing would have to maintain two separate cost systems: one for external reporting (the financial statements) and one for internal decision-making (ABC).

Now there are many reasons a company might not use ABC:
• Manufacturers would find it costly to maintain two cost systems
• It’s time-consuming to interview employees to identify the various cost pools
• Employees overstate the amount of time they spend on activities so they don’t look lazy
• ABC results in a massive amount of data, which takes time to analyze
• Implementing ABC takes a lot of time, and employees might resist the new system

0:00 Introduction
0:30 How activity-based costing differs from traditional cost systems
2:19 The steps involved with activity-based costing
2:54 Example of traditional cost system
4:00 Example of activity-based costing
5:34 Traditional vs. activity-based costing for manufacturers
6:38 Example of activity-based costing (advanced)
7:42 Why some companies don't use activity-based costing
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