Activity-Based Costing in 6 Easy Steps
Activity-based costing (ABC) assigns overhead to products based on the activities they actually use, like machine hours or quality inspections. Instead of one blanket rate, each overhead pool gets its own rate. The result is a more realistic overhead cost per unit for each product.
What you will learn
- What overhead cost pools and cost drivers are
- How to calculate an activity rate for each overhead pool
- How to assign overhead to each product based on what it uses
- How to get overhead cost per unit for each product
The formulas
- Cost pool total
- overhead cost of one activity, e.g. machine maintenance
- Cost driver
- what measures the activity, e.g. machine hours
- Driver quantity used
- how much of each activity the product consumes
- Units produced
- number of units of that product made in the period
Worked example
A phone maker has $400,000 of machine maintenance (10,000 machine hours) and $600,000 of quality control (1,000 inspections). PDA phones (3,000 units) use 5,500 hours and 650 inspections; simple phones (7,000 units) use 4,500 hours and 350 inspections. What is overhead per phone?
- Machine rate = $400,000 ÷ 10,000 hours = $40 per hour.
- Inspection rate = $600,000 ÷ 1,000 = $600 per inspection.
- PDA overhead = 5,500 × $40 + 650 × $600 = $220,000 + $390,000 = $610,000.
- Simple overhead = 4,500 × $40 + 350 × $600 = $180,000 + $210,000 = $390,000.
- Per unit: PDA = $610,000 ÷ 3,000 ≈ $203.33; simple = $390,000 ÷ 7,000 ≈ $55.71.
Answer: Overhead is about $203.33 per PDA phone and $55.71 per simple phone (rounded to the cent), versus a flat $100 each if you just spread $1,000,000 over 10,000 phones.
Common questions
What are the steps in activity-based costing?
Identify the main overhead activities, group their costs into pools, pick a cost driver for each pool, calculate an activity rate, assign overhead to products based on the driver quantities they use, and divide by units to get overhead per unit.
How do you calculate the activity rate?
Divide the total cost in an activity's cost pool by the total quantity of its cost driver. For example, $400,000 of machine maintenance over 10,000 machine hours gives an activity rate of $40 per machine hour.
What is a cost driver in ABC?
A cost driver is the measure that causes or tracks an activity's cost, such as machine hours, number of setups, inspections or orders. Products that use more of a driver get assigned more of that activity's overhead.
Why is activity-based costing more accurate?
Traditional costing spreads overhead with one rate, usually labor or machine hours. ABC uses several rates tied to the activities products actually consume, so complex, low-volume products stop being undercosted and simple, high-volume ones stop being overcosted.