What is Activity-Based Costing? A Managerial Accounting topic

What is Activity Based Costing?

In a traditional costing system, sometimes referred to as simple costing, costs are distributed evenly to the users of the costs. This can be not only an unfair process but also can lead management to make wrong decisions regarding product sustainability for the business.

For example, let us say there are three roommates: David, Matt and Brian. They began sharing the costs ($900 per months) equally but were not participating in the activities of living there equally. The activities that each roommate may have partook were eating, watching TV, and surfing the Internet.

Under the traditional costing system, the three roommates were distributing the costs equally to each roommate: $300 each. However, there were activities that certain roommates did not participate in and each felt as if they should not be responsible for those costs.

Therefore, the roommates called a meeting to discuss the allocation of the costs to each roommate.

Total costs actually consumed:
David: $215
Matt: $310
Brian: $375

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From this meeting, it was determined that Matt and Brian were getting a better deal under the traditional (simple costing) system but David was not. David was subsidizing the other two and their usage of activities that David was not participating in. This is an example of why businesses choose to use Activity-Based Costing. 

Activity-Based Costing is the allocation of costs based on the activity/activities that cause the cost. The goal of Activity-Based Costing is to allocate indirect costs more accurately to jobs/products to get a clearer picture of what each product costs to manufacture. This process helps managers make better decisions about the sustainability of products, business segments, branches, etc.

Cost Driver or Allocation Base

As a further example, consider a DVD manufacturer. Under a traditional costing system all of the manufacturing overhead costs are allocated to the products based on a cost allocation base. The allocation base is what is driving the costs. Therefore, the cost driver or allocation base could be machine hours, direct labor hours, units, etc. 

It is very important to note that choosing the correct allocation based is imperative to accurate cost allocation and decision making.  Most products go through multiple activities prior to becoming a finished product. Therefore, under an activity-based costing system, the DVD manufacturer would apply costs to a product dependent on the activities that the DVD went through. Each activity would be assigned an appropriate cost driver.

The activity-based costing system better allocates costs to each individual product/job and thereby gives management a more accurate picture of the cost of each product/job. This allows for future cost adjustments and budgeting processes.


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Additional Activity-Based Costing Examples

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