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ACTIVITY BASED COSTING (ABC)

Historical Development

Activity-based costing (ABC) is a costing approach that assigns resource costs to cost objects such as products, services, or customers based on activities performed for the cost objects. The premise of this costing approach is that a firm’s products or services are the results of activities and activities use resources which incur costs. Costs of resources are assigned to activities based on the activities that use or consume resources (resource consumption drivers), and costs of activities are assigned to cost objects based on activities performed for the cost objects (activity consumption drivers). ABC recognizes the causal or direct relationships between resource costs, cost drivers, activities, and cost objects in assigning costs to activities and then to cost objects.

ABC assigns factory overhead costs to cost objects such as products or services by identifying the resources and activities as well as their costs and amounts needed to produce output. Using resource consumption cost drivers, a firm determines the resource costs consumed by activities or activity centers (activity cost pools) and calculates the cost of a unit of activity. The firm then assigns the cost of an activity to products or services by multiplying the cost of each activity by the amount of the activity consumed by each of the cost objects. Traditionally cost accountants had arbitrarily added a broad percentage of expenses into the indirect cost. In addition, activities include actions that are performed both by people and machine. However, as the percentages of indirect or overhead cots rose, this technique became increasingly inaccurate, because indirect costs were not caused equally by all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another. Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products. Steps in Developing Activity Based Costing System:

Developing an activity-based costing system entails three steps: (1) identifying resource costs and activities, (2) assigning resource costs to activities, and (3) assigning activity costs to cost objects.

Step 1: Identify Resource Costs and Activities
The first step in designing an ABC system is to conduct an activity analysis to identify the resource costs and activities of the firm. Most firms record resource costs in specific accounts in the accounting system. Examples of these accounts include supplies, purchasing, materials handling, warehousing, office expenses, furniture and fixtures, buildings, equipment, utilities, and salaries and benefits. However, special effort most likely will be needed to determine appropriate resource costs for activity-based costing because generally several different resource costs may be recorded in a single account or the costs for an activity may be recorded in several accounts.

For example, a firm may use a single factory supplies account for all supplies in its operations that include several manufacturing operations. Costs to complete a purchasing order may be spread over several accounts including accounts for warehousing, purchasing, and receiving. Through activity analyses a firm identifies the work it performs to carry out its operations. Activity analyses include gathering data from existing documents and records, as well as collecting additional data using questionnaires, observations, or interviews of key personnel.

Levels of Activities

To identify resource costs for various activities, a firm...
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