ACTIVITY-BASED COSTING (ABC)

1. What is Activity-Based Costing (ABC)? 
Activity-Based Costing (ABC) is a costing method that assigns overhead costs to specific activities within a business. 
- Traditional costing allocates overhead costs based on direct labor hours or machine hours, which may lead to inaccurate cost calculations. 
- ABC assigns costs based on actual activities, providing more accurate insights into what drives costs. 

➡️ ABC helps businesses: 
- Identify which activities are profitable. 
- Eliminate or reduce unprofitable activities. 
- Improve cost control and operational efficiency. 

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2. Example: Cable Manufacturing Business 
You own a cable production business and want to understand overhead costs more accurately. 

Overhead Costs: 
- Electricity for machines = $500 per month 
- Maintenance costs = $200 per month 
- Cleaning staff = $100 per month 

Step 1: Total Overhead Costs 
Total Overhead = $500 + $200 + $100 = $800 

Step 2: Allocate Costs Based on Activity 
- Electricity → Machine usage = 60% 
- Maintenance → Machine maintenance = 25% 
- Cleaning → Facility upkeep = 15% 

➡️ Per unit overhead cost (if 1000 meters of cable produced): 
Per Unit Overhead = 800 / 1000 = $0.80 per meter 

✅ Each meter of cable includes $0.80 in overhead costs. 
✅ Knowing this allows you to adjust pricing or improve efficiency. 

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3. The Management Process 

ABC fits into the broader management process, which includes four key steps: 



1. Planning 
- CVP Analysis 
- Operational Budgeting 

2. Controlling 
- Activity-Based Costing (ABC) 
- Performance Monitoring 

3. Evaluating 
- Analyzing Investment Centers 
- Identifying Profitable Activities 

4. Decision-Making 
- Adjusting operations based on insights from ABC and CVP 

➡️ Example: 
If you discover that maintenance costs are too high, you might decide to change suppliers or reduce machine downtime. 

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4. Why ABC Matters 
- Provides more accurate cost assignment compared to traditional methods. 
- Helps identify high-cost and low-value activities. 
- Improves decision-making and pricing strategies. 

✅ Example: If you find that cleaning costs are increasing but provide no value to production, you can reduce or renegotiate cleaning contracts. 

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5. Common Mistakes to Avoid 
❌ Over-complicating the ABC model → Keep activity definitions simple. 
❌ Misallocating fixed and variable costs → Ensure accuracy in cost assignment. 
❌ Ignoring non-production costs → ABC includes both production and non-production costs. 

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