What Is Activity Based Costing?

The CIMA definition

CIMA describes ABC as tracing resource consumption and costing final outputs: resources are assigned to activities, and activities to cost objects. Two terms carry the whole idea - cost drivers (why the organisation consumes resources in an area, e.g. the number of supplier orders driving procurement cost) and cost objects (the things being costed, such as products or services).

Why ABC matters now

Modern production looks nothing like the environment absorption costing was built for:

• Overheads are now a much larger share of total production cost
• Not all overheads behave as fixed costs
• Diverse product ranges place very different demands on the same processes
• A complex product does not consume proportionally more of every resource than a simple one - and volume-based absorption pretends it does

The five-step ABC process

1. Estimate total overhead costs
2. Identify the distinct activities the business performs
3. Determine the cost driver for each activity
4. Calculate cost driver rates
5. Allocate costs to products using those rates

Worked example

A supplier-ordering budget of 171,000 dollars covers 360 orders across two products. The cost driver rate is 171,000 / 360 = 475 dollars per order. Each product is then charged 475 dollars for every order it actually generates - so the product that places 300 of those orders carries the overhead it causes, instead of sharing it by unit volume.