For example, the capacity of a warehouse or vehicle would be measured by space provided, while memory storage would be measured by megabytes supplied. In these situations, the manager would calculate the resource cost per unit based on the appropriate capacity measure, such as cost per cubic meter or cost per megabyte. This formula applies to all indirect costs, whether manufacturing overhead, administrative costs, distribution costs, selling costs, or any other indirect cost. After allocating these cost pools to each product $295,000 in overhead is allocated to the standard chairs and $705,000 in overhead is allocated to the custom chairs.

This is done by dividing estimated overhead costs for each activity by the estimated cost driver activity. For the activity meeting with customers, this calculation results in a rate per hour of meeting time. For the activity reviewing customer applications, the calculation results in a rate per application reviewed, and for running credit reports, a rate per credit report run. The company uses ABC costing to allocate manufacturing overhead costs to each product line based on the activities consuming those costs. Identifying and assigning costs to each activity lets you better understand the cost of your products or services and make more informed decisions about pricing specific products and resource allocation. Activity-based costing (ABC) is a costing method that assigns costs to specific activities or tasks within the production process.

Activity-Based Costing (ABC): Method and Advantages Defined with Example

Under traditional approaches, some idle capacity may be incorporated into the overhead allocation rates, thereby potentially distorting the cost of specific output. This may limit the ability of managers to truly understand and identify the best business decisions about product pricing and targeted production levels. Activity-based costing focuses on identifying the activities required to make products, on forming cost pools for each activity, and on allocating overhead costs to the products based on their use of each activity.

If a loan officer reviews 30 auto loan applications, an amount equal to the rate per application reviewed times 30 applications is allocated to the auto loans product. The identification of cost components is the cost drivers involved in different activities. Cost drivers or cost objects are the factors that impact the cost of a particular activity.

Traditional Costing Vs. Activity-Based Costing

Nowadays, it just simply isn’t the case that if something’s produced in a larger volume, it necessarily places bigger demands on the business in every single area of the production process. And rather than thinking about things at a departmental level, which we often do with absorption costing, ABC offers a much more detailed approach of breaking a business down into its different activities. In defining ABC, first of all, what we would say is it is a more complex system of cost bookkeeping for startups accounting than absorption costing. ABC gives us a much more detailed look at the manufacturing part of a business if we’re talking about a manufacturing organisation. The ABC provides information about the cost incurred on each production activity; with that help, the management can decide which activity is profitable to perform domestically and which is required to be outsourced. Management can outsource any activity if that incurs a higher cost domestically than outsourcing.