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What Is Activity-Based Costing? Definition and Examples

August 30, 2019

When running a business, profits are everything.

To reach your entrepreneurial goals, you’ll need to order your calculations in an organized, efficient way to ensure that your numbers are matching up with the path you want to be on. Activity-based costing is a helpful metric you can use to quantify the costs related to producing the products and services that are the lifeblood of your business.

This article goes over how to calculate your cost-per-activity as well as the benefits and drawbacks of activity-based costing, one of many accounting terms that can be put to use to help keep your company's financials in order.

Activity-based costing: how to use, benefits, and drawbacks

To calculate activity-based costing, a few variables need to be identified. 

First, you must label all of the activities necessary to create your product or service. Once these are identified, you’ll have to sort each one by the costs associated with producing each product or service. Below, we’ll go through the steps that you can use to calculate the cost-per-activity of producing your products and services using activity-based costing. 

How to use activity-based costing 

There is a simple, three-step method for calculating the cost-per-activity using activity-based costing. 

1. Sort your overhead costs by activity

The first step in calculating cost-per-activity using activity-based costing is to sort all of the money you spend on your products and services, also known as overhead costs, into categories. These categories are called cost pools, which will be identified by the activity that consumes the costs. 

An example of a cost pool could be the cost of a maintenance department or a quality control department. 

Essentially, you’re beginning to sort through all of your company’s costs by determining which costs come from which department or type of activity.

2. Identify what activity drives each cost

Next, you’ll want to get a bit narrower with how you sort these costs by determining the cost drivers. 

For example, a maintenance department’s costs can arise from a specific number of leaks or plumbing issues. A quality control department’s costs can come from problems that require a higher number of thorough inspections and meetings. 

For this step, you’ll need to have a barometer on what activities each department in your company is responsible for, and how many of these activities were conducted by each department in the given time frame you are calculating cost-per-unit for.  

3. Calculate

Finally, you’ll calculate how much each individual cost-driver, such as repairs or inspections, is costing your company. You can determine this by dividing the cost pool by the number of cost drivers for each department. 

For example, you would divide the cost pool for a maintenance department in a given period by the number of repairs that were made in that same given period. 

This calculation yields your cost-per-activity.

Benefits of activity-based costing

Activity-based costing helps a company sort out its cost more effectively and orderly by necessitating separating costs by activity. Essentially, it offers clarity to a sea of costs that can sometimes seem indirect and without cause. 

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When tracking the costs that your business incurs, you’ll want a system in place that makes identifying the sources of costs as easy as possible. Activity-based costing provides this structure and allows for a business to access a more accurate measurement for the cost of each unit they produce, be it material or a service.

Drawbacks of activity-based costing

There are, however, a few disadvantages to using activity-based costing. Activity-based costing is most typically used in manufacturing.As industries and workflows have evolved, the amount of overheads (the costs that go into making individual products) have become a larger proportion of total costs. 

Workflows have become more automated through technological advancements and machine learning instead of labor-dependent. Additionally, products have become more unique and specialized as markets have become more saturated. If these overhead costs make up the majority of the costs for a company, activity-based costing may be of limited benefit.

Get costing

Now that we’ve outlined the basics of activity-based costing, you can go ahead and implement it in your business’s accounting plan. And if you are looking for automated help with your company’s accounting needs, feel free to check out G2’s guide to the best accounting software.

See the Highest-Rated Accounting Software →

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