Activity-based costing is a two-stage costing method that creates a cost pool for each major activity in an organization (such as setups required, purchase orders issued, and so on). Overhead costs are assigned to products and services on the basis of the number of iterations of each activity involved in manufacturing the product or providing the service.
Activity-based costing (ABC) is a better, more accurate way of allocating overhead.
The steps to product costing are:
1. Identify the cost object;
2. Identify the direct costs associated with the cost object;
3. Identify overhead costs;
4. Select the cost allocation base for assigning overhead costs to the cost object;
5. Develop the overhead rate per unit for allocating overhead to the cost object.
Activity-based costing refines steps #3 and #4 by dividing large heterogeneous cost pools into multiple smaller, homogeneous cost pools. ABC then attempts to select, as the cost allocation base for each overhead cost pool, a cost driver that best captures the cause and effect relationship between the cost object and the incurrence of overhead costs. Often, the best cost driver is a nonfinancial variable.
ABC can become quite elaborate. For example, it is often beneficial to employ a two-stage allocation process whereby overhead costs are allocated to intermediate cost pools in the first stage, and then allocated from these intermediate cost pools to products in the second stage. Why is this intermediate step useful? Because it allows the introduction of multiple cost drivers for a single overhead cost item.
ABC focuses on activities. A key assumption in activity-based costing is that overhead costs are caused by a variety of activities, and that different products utilize these activities in a non-homogeneous fashion. Usually, costing the activity is an intermediate step in the allocation of overhead costs to products, in order to obtain more accurate product cost information. Sometimes, however, the activity itself is the cost object of interest.
Activity base costing system is more useful where the proportion of fixed expenses are higher in total cost of manufacturing.