Activity-Based Costing

Allocating overhead costs based on “activities” that actually contribute to overhead costs

What is Activity-Based Costing?

Activity-based costing is a more specific way of allocating overhead costs based on “activities” that actually contribute to overhead costs. In job-order costing and variance analysis, overhead costs are applied based on a specific cost driver such as labor hours or machine hours.

Activity-based Costing

An activity is an event, task, or unit of work with a specific purpose, whether it be designing products, setting up machines, operating machines, or distributing products. Therefore, activity-based costing considers all the potential activities instead of relying on just one variable (either labor hours or machine hours).

Generally, activity-based costing is used in the manufacturing industry, as it produces more accurate cost data, generating values that are close to the true cost and can be identified during the production phase.

Activity-based costing serves and complements many other analyses and measures, including target costing, product costing, product line profitability analysis, service pricing, and more. Thus, it is used to better understand the company’s true costs, and thereby formulate an appropriate pricing strategy to mitigate unnecessary expenses.

Labor Hours Approach vs Activity-Based Approach

Let take a look at the following example to compare the differences:

XYZ Company manufactures and sells two types of tables: Standard and Luxury. Annual sales, direct labor hours, and total direct labor hours per year are provided below:

Standard: 2,000 units * 5 labor hours per unit10,000
Luxury: 10,000 units * 4 labor hours per unit 40,000
Total Labor Hours50,000

Costs for materials and labor for each table are provided below:

Direct Materials$25$17
Direct Labor ($12 per hour)$60$48

Manufacturing overhead costs total $800,000 every year. The breakdown of these costs among the company’s six activity cost pools is given below. The following six activities contribute to overall overhead costs.

 Estimated MOHStandardLuxuryTotal
Labor related$80,00010,00040,00050,000
Machine setups$150,00030002,0005,000
Parts administration$160,000503080
Production orders$70,000100300400
Material receipts$90,000150600750
General factory machine hours $250,00012,00028,00040,000

Using the predetermined overhead rate approach with labor hours, the predetermined overhead rate is equal to $16 per labor hour ($800,000 / 50,000 labor hours). Using this information, we can design a cost card for each product.

Unit Cost Card Using Labor Approach

Direct materials$25$17
Direct labor$60$48
Manufacturing overhead applied:
Standard: 5 labor hours * $16 per labor hour$80
Luxury: 4 labor hours * $16 per labor hour $64
Unit product cost $165$129

Activity-Based Approach to Determine Overhead

Using the activity-based costing approach, we can determine overhead rates for each activity that is relevant to production. The activities listed below are given in this example but companies usually break down the relevant activities.

ActivityEstimated MOHTotal per ActivityOverhead Rate
Labor related$80,00050,000 hours$1.60 per labor hour
Machine setups$150,0005,000 setups$30.00 per setup
Parts administration$160,00080 parts$2,000 per part
Production orders$70,000400 orders$175 per order
Material receipts$90,000750 receipts$120 per receipt
General factory machine hours $250,00040,000 machine hours $6.25 per machine hour

Next, for each product, we can use the calculated overhead rates to determine the overhead numbers:

 Standard Luxury 
ActivityExpected ActivityOverhead appliedExpected ActivityOverhead applied
Machine setups3,000$90,0002,000$60,000
Part administration50$100,00030$60,000
Production orders100$17,500300$52,500
Material receipts150$18,000600$72,000
General factory machine hours 12,000$75,00028,000$175,000
Units produced2,000Units produced10,000
Overhead cost per unit$158.25Overhead cost per unit$48.35

Under the activity-based approach, the unit cost card gives different unit product costs for each product.


Unit Cost Card Using Activity-Based Approach

Direct materials$25$17
Direct labor$60$48
Manufacturing overhead applied:
Standard: 5 labor hours * $16 per labor hour$158.25
Luxury: 4 labor hours * $16 per labor hour $48.35
Unit product cost $243.25$113.35


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Benefits of Activity-Based Costing

Activity-based costing (ABC) can affect the cost distribution process in three ways:

  1. The allocation of overhead costs is more accurate and precise as they are separated and grouped into pools based on the number of activities. To simplify, rather than calculating the indirect expenses of the company by pooling all costs together, ABC pools costs based on activity.
  2. Activity-based costing traces previously untraceable costs, such as depreciation, to particular activities.
  3. The ABC method can also change the unit cost of low-volume products by transferring overhead costs from high-volume products.

Concluding Remarks

By comparing the first unit cost card (i.e., when manufacturing overhead is applied based on just one variable: direct labor hours) and the second unit cost card (i.e., when manufacturing overhead is applied based on several important activities), we can see that the unit product cost for each product is generally similar. However, the activity-based approach is the more specific and precise way that companies will allocate their manufacturing overhead costs.

For the standard product, we can see that the manufacturing overhead cost per unit is much lower for the regular labor-based approach. In producing the product, more overhead costs were actually put into the process than estimated by the labor approach.

In contrast, for the luxury product, manufacturing overhead costs based on labor hours were higher when compared to the activity-based approach. When considering all relevant activities, overhead costs in manufacturing each product are actually less than that estimated by labor hours only.

Therefore, even though labor hours or machine hours may be a good starting point for companies to get a general idea of potential overhead costs, they can use activity-based costing as an alternative if they are looking to get a more exact assessment of overhead.

Related Readings

Thank you for reading the CFI guide to activity-based costing. To learn more about costing and accounting, see the following CFI resources:

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