Activity-Based Costing: Advantages, Definition and When To Use

By Indeed Editorial Team

December 16, 2021

An important part of business success is reducing overhead costs and maximizing profits. Before you can do that, though, you need to account for all direct and indirect costs. Activity-based costing is one method of doing this and it offers many benefits when compared to other accounting methods. In this article, we discuss what activity-based costing is and some activity-based costing advantages and disadvantages.

What is activity-based costing?

Activity-based costing is a process of calculating the cost of products that accounts for indirect costs. It is a process of tracking resource use and pricing final outputs. The goal of activity-based costing is to assign specific resources to objects. It specifically identifies the activities that cause production costs to increase, helping team leaders make more informed pricing and manufacturing strategies.

Activity-based costing includes the following steps:

  1. Identify activities that are required to complete a product.

  2. Trace costs to activities and objects and then assign them to different pools.

  3. Assign specific drivers to each pool, like an hour or unit.

  4. Calculate cost driver's rates by dividing overhead costs by total cost drivers.

  5. Divide the total overhead of each pool by total cost drivers to get the cost driver rate of each.

  6. Multiply your cost driver rate by the number of cost drivers.

You can compare activity-based costing to absorption-costing. Absorption-costing refers to equally assigning the value of overhead costs across all inventory. This accounting method doesn't account for products that may have higher indirect costs, but activity-based costing does.

Read more: How To Calculate Activity Based Costing

Activity-based costing advantages

There are many advantages to using activity-based costing, such as:

It gives you a realistic and more accurate production cost of specific items

Activity-based costing gives managers more accurate production costs. This can help businesses make more informed decisions about which products to produce or help them find cheaper methods of production. It can also help when determining pricing for individual products.

In addition to having a clearer understanding of the manufacturing costs, the process of gathering the data is also easy with activity-based costing. Most management members can identify the costs of each activity once they have the necessary data. This may also help with making production decisions that affect pricing.

Related: Absorption Costing: Definition, Tips and Examples

It allows you to assign specific overhead costs to more expensive products

Instead of assigning an equal value to all products, you can allocate the necessary budget in each area when using activity-based costing. Some products may be costlier to produce, depending on their indirect costs. This can also help with identifying costs that apply to more than one pool of manufacturing products, which can make resources more valuable.

Related: How To Calculate Manufacturing Cost

It allows you to evaluate the efficiency of productions and make improvements

This method allows managers to assign value to indirect costs, treating them as if they were direct costs. By breaking down the indirect cost of each activity, they can make improvements. Managers can use the activity-based costing method to evaluate things like management influence, efficient processes and the overall cost of different departments.

It gives you more accurate data for profit margins

Because activity-based costing accounts for non-manufacturing costs or indirect costs that you may not have otherwise considered, it can help with improving profit margins. Having more accurate profit margins can help business leaders make important decisions. It can also help reduce or transfer production costs, allowing management to improve their profit margins even further with effective pricing strategies.

Managers can easily identify products of little to no value when using activity-based costing. They can use this information to remove products from inventory and to allocate those manufacturing resources to more profitable items. It also makes it easier to identify products that can be wasteful when it comes to required resources. Some products may not only be of low value but also use necessary resources.

Related: What Is Profit Margin?

It provides benefits in industries that other methods don't work

Traditional costing methods don't always work in certain industries, such as the service industry. This is because service industries have minimal direct costs. However, you can use activity-based costing in these industries since you apply the cost directly to the type of service. This means you can use it to improve results and pricing in industries that are otherwise left out.

Activity-based costing disadvantages

It is important to consider the potential disadvantages of activity-based costing when choosing the right method. Here are a few potential disadvantages to consider:

It can be more time-consuming

Activity-based costing can be a more time-consuming process. Instead of calculating total costs and dividing them equally over all products, team members have to evaluate the costs of each product manually. They have to go through the process of dividing products into different pools.

Businesses may need to assign a team to this specific task, but they may also choose to outsource it. This can be a better method as this process usually requires a team of management-level employees. Additionally, when you outsource this task to a team that specifically focuses on activity-based costing, the team is usually already familiar with the programs.

It can require more resources to gather accurate data

Gathering data for individual products can be time-consuming and costly. Businesses may have to hire or assign team members for the task, affecting payroll, and you may also need to purchase data collection software. Some businesses choose to outsource the process, which can also cost the business. However, there may be options available to help streamline the process for a more efficient and cost-effective process.

It may be difficult without data readily available

Depending on the manufacturing systems or programs that you use, the information you need may not always be readily available. Collecting the data you need may require the use of specific software. Also, the reports you use when collecting this type of data don't always follow the traditional guidelines for accounting principles, which can make things harder to track for some teams.

All production and manufacturing teams may need to train on the new activity-based costing process and programs. However, once they do, the process typically becomes easier for everyone. Gathering the data you need, as long as you have the right resources and team members, can be beneficial.

It may not be an option for smaller companies

Smaller companies that have small overhead costs may find that using activity-based costing is not as efficient as other options. They are also more likely to use market-based costs when calculating data, which doesn't always align with activity-based costing. You may most often find activity-based costing in the manufacturing industry. However, it is proving to be beneficial in other industries, too.

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