Activity-Based Costing

Learning Outcomes

  • Describe situations in which activity-based absorption costing is used

Activity-based absorption costing assigns all manufacturing overhead costs to products based on the activities performed to make those products.

In this method, we look only at non-direct costs. Direct costs are easily traced to an activity, so we don’t need to do anything further with those costs. Non-direct costs are the overhead costs, such as rent, property taxes, accounting and administrative costs and all other costs not directly related to the production of our product.

Activity-based absorption costing (ABC) is much more complicated that traditional costing, but can give you a much better allocation picture.  Let’s look at an example where ABC may produce a better picture for a company.

Example

You are a manager at a company that makes two kinds of kayaks: the basic model and the deluxe. Currently, you are using a traditional costing method and assigning manufacturing overhead based on direct labor hours. So all of the direct labor and materials are being charged to each of the models, and then the overhead is allocated. But what if the deluxe kayak is consuming three times as much machine time due to more frequent setups? Or what if there are more parts in the deluxe model requiring a great deal more time in the purchasing department? These activities could cause traditional costing to be “off” compared to costing based on each activity.

This is a situation, where ABC may be more reflective of the actual cost allocation. It is necessary to determine if the benefits of implementing the ABC method outweigh the costs. After doing an evaluation of your situation, then the decision can be made regarding which method to utilize.

Practice Questions

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