Activity based costing (ABC) is costing method, under which all costs are allocated to company activities according to what are the drivers of the activities. Costs are then allocated to products based on product´s consumption of these activities.
ABC was developed to overcome the disadvantages of absorption costing, is very appropriate for pricing and product prioritization considerations.
Costs of the product/service under ABC costing method include direct costs and allocated share of production and usually also non-production overheads as well.
But unless this method is adjusted, it is not acceptable for inventory valuation under IFRS and US GAAP - mainly because it allocates to product also selling and administrative overheads.
Basic steps for Activity based costing (ABC)
- Make a list of activities carried out by the entity and their drivers.
- Split the costs according to these activities (by that you will prepare so called cost pools) and split them according to drivers of these activities (so called cost drivers).
- Calculate costs per unit of the cost driver (overhead absorption rate).
- Allocate costs to individual cost objects (most often products/services) based on their consumption of activities.
Examples of costs allocated to the cost drivers:
- direct production costs → number of units produced
- ordering costs → number of orders
- electricity costs → kilowatt hours
- quality control costs → number of defective items or hours spent on control
- product design → number of designer hours
- packaging / dispatching costs → number of units dispatched
Advantages of using Activity based costing (ABC)
- Fairer allocation of overheads resulting in more accurate product/service costs – especially for products with lower sales volumes, because these tend to be under-allocated under absorption costing.
- Due to its multiple cost drivers it better reflects dissimilar production process, its complexity or wider product ranges.
- Helps better control costs by analyzing cost drivers.
- Valuable method for product pricing and decisions about the portfolio (prioritization, make or buy decisions etc.).
- Method is strongly recommended for entities with great diversity of products and with high overheads, where it wouldn´t be fair to allocate costs only based on only one activity.
Disadvantages of using Activity based costing (ABC)
- Some costs may not have any cost driver or can have more than one cost driver (e.g. CFO salary, statutory audit fees).
- Time-consuming, difficult and costly implementation; therefore often carried out by large companies only.
- Sometimes difficult to explain to management due to its complexity.
- It does not comply with US GAAP or IFRS, mainly because it allocates also selling and administrative overheads to the value of inventory.
When is Activity based costing (ABC) less useful
ABC is less useful (or maybe does not make sense), if the entity:
- produces a single product (provides a single service)
- does not have many different activities driving the costs
- cannot influence selling price of its products (e.g. regulated industries) → cannot increase the price anyway if the product is found unprofitable
- makes its products based on specific customer requests
- is a small company, where implementing ABC would cost more than the benefits resulting from the information it produces