Traditional costing methods often assign broad, arbitrary percentages to allocate indirect costs (overhead) to products or services. Similarly, often only manufacturing overhead costs are assigned to products, where selling, general and administrative costs are treated separately as period expenses.
Despite this, many activities, such as sales costs, can be traced to individual products. Activity-based costing looks at all activities that cause the consumption of overhead resources. Costs are then allocated to products or customers based on the extent that the activity is used up by the product. As a result, we are able to more clearly identify areas with high overhead costs per unit.
Under activity-based costing, products are only charged with the capacity they use, and unused capacity is treated as period cost. This highlights the cost of unused capacity, as opposed to burying it in inventory and cost of goods sold. Unit costs remain more consistent as well.
Cost pools are created by pooling costs that relate to a single activity measure. Activity rates are determined by dividing the total cost from the previous years activity cost pool by the total activity. For example, if $100,000 of costs were incurred handling customer orders, and there were 1,000 orders, an activity rate of $100/order would be determined.
Activity-based costing emerged as a practice in manufacturing industries. Automation in manufacturing increases the amount of fixed costs attributable to a product (depreciation of machinery) and reduces variable costs (such as direct labor). As a result, it is important to reflect these new, higher fixed costs more accurately for decision-making purposes. Similarly, we see the use of activity-based costing in industries such as health-care and banking, where personnel costs, often customer-related costs, are high and are used by a variety of different products.
Activity measures include:
: Activities that arise as a result of the total volume of goods and services that are produced and are performed each time a unit is produced.
: Activities that are performed each time a batch of goods is handled or processed, regardless of how many units are in a batch. The amount of resource consumed depends on the number of batches run, rather than the number of units in the batch.
: Activities related to specific products that must be carried out regardless of how many units are produced and sold or batches run.
: Activities that are carried out to support customers but are not related to any specific product.
: Activities that are carried out regardless of which customers are serviced, which products are produced, how many batches are run or how many units are made.
Garrison, Ray H et. al. (2009). Managerial Accounting: Eighth Canadian Edition. McGraw-Hill Ryerson. Toronto.