Activity-based costing (ABC) traces overhead to the work that uses it. In this example, we’ll follow two costs, machine setups and inspections, from the accounting records to the products. Then we’ll see what to check before using the results to make a decision.
🎥 Watch the Complete Lesson
Activity-Based Costing: A Step-by-Step Example
The companion lesson walks through the calculations and shows how to review an ABC model at month-end.
📘 Step 1: Identify the Work That Uses Overhead
A broad rate based on production volume can work when products consume overhead in similar ways. When the work differs by product, ABC starts by asking which activities use the resources.
- Activity. Work that uses resources, such as preparing equipment for a production run.
- Cost pool. Overhead grouped around that work, such as machine-setup labor and supplies.
- Cost driver. A measure of the work used to assign the pool, such as the number of setups.
- Cost object. What you’re measuring, such as a product, order, service, or customer.
Use a driver that reflects the activity. Setup counts can work when setups are similar. If one setup takes fifteen minutes and another takes half a shift, setup hours may explain the cost better.
🧾 Step 2: Trace the Costs to the Accounting Records
The general ledger records overhead in accounts such as wages, supplies, utilities, and depreciation. Time tickets, activity codes, and supporting schedules identify the work behind those costs. Setup and inspection logs can supply the driver counts.
Suppose a technician spends six hours on setups at $50 per hour. The business records $300 of labor cost. The activity code also identifies that same $300 for the setup pool. The pool is a way to group the recorded cost, so the $300 enters the books once.
🧮 Step 3: Calculate Each Activity Rate
Activity rate = Cost pool ÷ Total driver quantity
| Activity | Pool cost | Driver quantity | Rate |
|---|---|---|---|
| Setups | $24,000 | 48 setups | $500 per setup |
| Inspections | $18,000 | 90 inspections | $200 per inspection |
📊 Step 4: Assign Costs Based on Product Usage
Multiply each rate by the number of setups or inspections the product used. Product A required six setups and ten inspections. Product B required two setups and twenty-five inspections.
| Product | Setup cost | Inspection cost | Total |
|---|---|---|---|
| A | 6 × $500 = $3,000 | 10 × $200 = $2,000 | $5,000 |
| B | 2 × $500 = $1,000 | 25 × $200 = $5,000 | $6,000 |
Product B receives $1,000 more in overhead. Its higher inspection cost more than offsets its lower setup cost. The two products account for $11,000 of the $42,000 in the pools. A full reconciliation would also account for the rest of the activity and any documented unassigned costs.
✅ Step 5: Reconcile the Pools and Check the Drivers
If the ledger shows $42,000 in overhead for the model and your pool schedule shows $39,000, trace the $3,000 difference. Check for uncoded transactions, timing differences, and documented exclusions. Once the pool totals are supported, reconcile the assignments plus any documented unassigned cost back to the pools.
Then check what the numbers mean. A standard product that uses one setup and a custom product that uses five might both receive $300 under a broad allocation. That’s a reason to check the driver and the usage records. Other warning signs include pooling activities that behave differently, counting unused capacity as product usage, or carrying outdated driver quantities forward.
📈 Step 6: Explain What Changed in the Margin
Suppose a broad allocation assigns $30 of overhead to a standard unit and $30 to a custom unit. ABC assigns $20 and $40 because the custom unit uses more setup and inspection work. With selling prices and other costs held constant, the standard unit’s margin rises $10 and the custom unit’s falls $10.
The same $60 of overhead is distributed differently. This changes the internal profitability comparison. If those costs flow through inventory and cost of goods sold, the timing of reported costs can also depend on when the products sell and how the reporting costs are determined.
📋 Step 7: Make ABC Part of the Monthly Close
At month-end, ask whether the pools reconcile to the ledger, whether the driver counts are complete, and whether someone can explain unusual changes. In a separate example, a $20,000 setup pool spread across 40 setups gives a $500 rate. Spread across 50 setups, the rate falls to $400. The cost pool stayed the same while the number of setups increased.
Review the model in order. Trace the pool to the ledger, validate the driver total, recalculate the rate, and apply it to documented product usage. Record any unresolved difference and who will follow up before relying on the margin.
🎯 Step 8: Pilot One Pool Before Expanding
Start with one overhead pool that could affect a decision. Assign someone to maintain the driver data and run the pilot alongside the existing method for the same period and cost scope.
For a separate pilot order that uses three setups at $500 each, ABC assigns $1,500 in setup cost. If the existing method assigned $900 to that same order, investigate the $600 difference. Check the setup log, confirm that both methods cover the same costs, and ask whether scheduling or batch size explains the additional work. Use what you find before deciding whether to change pricing or production.
Complimentary Financial Health Check
If you’re unsure whether your books are current, reconciled, and detailed enough to support decisions like these, request a Complimentary Financial Health Check. The review can help you identify bookkeeping questions that deserve a closer look.
👤 About the Author
Dr. Brian Routh is an accounting professor and professional bookkeeper who helps business owners keep accurate books and understand the financial information behind their decisions.
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