What Is Activity-Based Costing? (Definition And Advantages)

By Indeed Editorial Team

Published 29 September 2022

The Indeed Editorial Team comprises a diverse and talented team of writers, researchers and subject matter experts equipped with Indeed's data and insights to deliver useful tips to help guide your career journey.

A critical aspect of running and operating a product-focused business is allocating expenses, reducing overhead costs and maximising profits. Activity-based costing, or ABC, is an effective method to determine overhead costs, and it offers many benefits compared to traditional costing methods. Knowing more about ABC can help you determine a product's correct pricing and reduce a company's overhead costs. In this article, we discuss what the ABC accounting method is, review its requirements, outline its advantages and disadvantages and explain the difference between traditional and ABC accounting methods.

What Is Activity-Based Costing?

Activity-based costing, or ABC, is a method that identifies and assigns overhead and indirect costs, such as utility bills and salaries to products and services. It primarily determines the total cost associated with creating or manufacturing a product. The objective of ABC is to assign specific resources and break overhead costs between production-related activities. This type of costing relies on different activities, such as product design or unit of work. Typically, ABC works in complex environments involving many machines, tangled processes and products that are difficult to sort. Conversely, companies might not prefer ABC in streamlined processes.

ABC helps managers make informed manufacturing and pricing strategies and determine activities that cause production costs to increase. This cost provides managers and teams with an accurate overview of the production cost associated with a single item. It helps managers determine which items or products they might want to keep producing. Using the ABC accounting method, a company can perform an activity assessment to identify and understand the cost drivers rather than assigning costs to generic measurements. This provides an accurate idea of profitability and the actual cost of production.

Related: What Is Cost Accounting? (Definition And Objectives)

Requirements For Activity-Based Costing

The ABC accounting method works on the concept of activities, which can be events, units of work or tasks with specific goals like setting up machines, designing products, operating machines and distributing finished goods. Under ABC, activity is any transaction or event that works like a cost driver. A cost driver or activity driver refers to the resource allocation base.

Some examples of cost drivers include purchase orders, production orders, quality inspection, maintenance requests and machine setups. Traditional costing depends upon volume counts, such as direct labour and machine hours and allocates direct and indirect overhead costs. The ABC system classifies the cost based on five-broad activities, including unit-level activity, batch-level activity, organisation sustaining activity, product-level activity and unit-level activity.

Related: What Is Standard Costing? (With Formula And Example)

Advantages Of ABC

The primary advantage of the ABC accounting method is accurately determining the overhead costs required for creating or manufacturing a product. Some other advantages of using ABC are:

Provides benefits in industries where other methods do not work

Traditional accounting methods might not work in specific industries, such as the service industry. This is because the service industry has minimal direct costs. Even then, you can use the ABC accounting method since you can directly apply these costs to the type of service the company provides. It can help you improve pricing in the service industry and improve results.

Gives accurate data for profit margins

As the ABC accounting method considers the non-manufacturing and indirect costs, it can improve a company's profit margin. When a company has accurate profit margins, it becomes easier to make essential business decisions. It can help reduce production costs, allowing the company to enhance their profit margin while improving its pricing strategies. Using ABC, managers can identify products of no or little value, which helps customers remove products from inventory and allocate resources to more profitable products. It can help in reducing wastage and channelise resources into more productive items.

Related: What Are Profitability Ratios? (With Types And Examples)

Evaluates the efficiency of productions

Companies can use the ABC accounting method to evaluate the influence of management, efficient processes and the overall cost of different departments. Companies can use the ABC accounting method to assign value to indirect costs, treating them as direct costs. Understanding the indirect cost of each activity makes it easier to make improvements.

Provides insight into the distribution cost

Typically, a company uses various channels, such as retail stores, distributors and online stores. For a company, distribution costs are overhead costs and the ABC system breaks these costs based on the requirement of each channel. When a company has information about the distribution cost of each channel, it becomes easier to choose the most profitable channel.

Related: How To Calculate Variable Cost in 3 Steps (With Examples)

Gives details about facility costs

Using the ABC accounting method, organisations can understand the overhead cost of the production facility. This helps managers and management understand production expenses at different facilities. With information about facility costs, managers can select the right strategies to help companies save money.

Helps in creating a budget

The ABC accounting method can help a company identify areas where it spends its money. When a company creates their budget, they try to get as specific as possible about the incoming and outgoing money in the organisation. When managers know about activities on which they might overspend, they can search for new methods for reducing the overall cost.

Related: What Is Zero-Based Budgeting? (Advantages And How To Create)

Helps in product pricing

Another benefit of using ABC is ensuring accurate product pricing. Product pricing is a challenging decision to make. Failing to account for all these costs can lower the pricing of your products. As a result, a company might not incur the desired profit margin. ABC method helps managers assign the cost of each activity. Using this data, managers can account for every cost a company incurs to create or manufacture a product.

Related: 9 Pricing Tools To Consider (With Definition And Examples)

Disadvantages Of ABC Accounting Method

Although the ABC accounting method is an effective accounting tool, it has certain disadvantages. Some disadvantages of using the ABC accounting method are:

Requires lengthy installation time

Installing the ABC accounting method can be challenging and time-consuming, especially for large companies. Instead of calculating the total cost and dividing the cost equally over products, the accounting team calculates the cost of each product individually. The process of splitting products into various pools is time-consuming.

Requires more resources to gather data

Gathering the cost associated with each product is costly and time-consuming. A company might purchase data collection tool to gather data. Often, the company might hire additional employees, affecting the payroll. When a business outsources the process, it might be an additional cost to the business.

Provides less accuracy

Typically, no accounting method provides a company with accurate cost details. For instance, the ABC accounting method requires employees to track their time on each activity. Employees might miscalculate or exaggerate the time they spend on each activity. Though ABC costing is more valuable and accurate than traditional costing, it is not completely accurate.

Requires additional data

This accounting method cannot retrieve all the required information from the general ledger because the accounting method requires other types of costs. ABC accounting method requires a separate database to retrieve information from several sources, only one of which is the general ledger. Maintaining this extra database requires significant staff for which a company might not have the budget.

Makes it challenging for smaller companies to use

Smaller companies have smaller overhead costs, making the ABC accounting method an inefficient process for these companies. These smaller companies use market-based costs for calculating and gathering data that might not align with ABC. Also, manufacturing companies widely use the ABC accounting method, but other industries also leverage its benefits.

Collects data only once

When a company uses ABC data collection in the accounting system, they ensure that the information is correct and available for future ABC requirements. Often, ABC is on a project basis, meaning that professionals collect information only once. As operations and requirements change over time, the information becomes less valuable.

ABC Vs Traditional Costing

ABC is an alternative accounting method to traditional costing. While traditional costing allocates the overhead products of the factory depending upon the volume of production resources consumed, ABC focuses on activities performed to produce or manufacture products. The ABC system accumulates costing into activity cost pools and corresponds to major activities or business processes. Typically, a single cost driver determines the cost in each cost pool.

Traditional costing accumulates costs into departmental or facility-wise cost pools. The cost does not depend upon a single factor or cost driver. Also, traditional costing is suitable for low overhead and labour-intensive companies, whereas ABC is ideal for capital-intensive and product-diverse companies.

Explore more articles