Activity-Based Costing in 6 Easy Steps
Activity-based costing (ABC) assigns overhead to products based on the activities they actually use, like machine hours or quality inspections. Instead of one blanket rate, each overhead pool gets its own rate. The result is a more realistic overhead cost per unit for each product.
Activity-based costing explained simply
Activity-based costing (ABC) assigns overhead to products according to the activities they use, with a separate rate for each cost pool: activity rate = pool cost ÷ total driver quantity. In the example, overhead is about $203.33 per PDA phone and $55.71 per simple phone, instead of a flat $100 each.
What this activity-based costing lesson covers
- What overhead cost pools and cost drivers are
- How to calculate an activity rate for each overhead pool
- How to assign overhead to each product based on what it uses
- How to get overhead cost per unit for each product
Activity-based costing formulas, explained
- Cost pool total
- overhead cost of one activity, e.g. machine maintenance
- Cost driver
- what measures the activity, e.g. machine hours
- Driver quantity used
- how much of each activity the product consumes
- Units produced
- number of units of that product made in the period
How to do activity-based costing step by step (worked example)
A phone maker has $400,000 of machine maintenance (10,000 machine hours) and $600,000 of quality control (1,000 inspections). PDA phones (3,000 units) use 5,500 hours and 650 inspections; simple phones (7,000 units) use 4,500 hours and 350 inspections. What is overhead per phone?
- Machine rate = $400,000 ÷ 10,000 hours = $40 per hour.
- Inspection rate = $600,000 ÷ 1,000 = $600 per inspection.
- PDA overhead = 5,500 × $40 + 650 × $600 = $220,000 + $390,000 = $610,000.
- Simple overhead = 4,500 × $40 + 350 × $600 = $180,000 + $210,000 = $390,000.
- Per unit: PDA = $610,000 ÷ 3,000 ≈ $203.33; simple = $390,000 ÷ 7,000 ≈ $55.71.
Answer: Overhead is about $203.33 per PDA phone and $55.71 per simple phone (rounded to the cent), versus a flat $100 each if you just spread $1,000,000 over 10,000 phones.
Overhead per phone under three methods
| Method | PDA phone | Simple phone |
|---|---|---|
| Flat rate per unit ($1,000,000 ÷ 10,000) | $100.00 | $100.00 |
| Plantwide machine-hour rate ($100 per hour) | About $183.33 | About $64.29 |
| Activity-based costing | About $203.33 | About $55.71 |
Which overhead number is the true one? David's take
The same $1,000,000 of overhead gives a PDA phone a cost of $100, about $183 or about $203, depending only on what you divide by. Nothing about the phone changed; the choice of variables did. My concept 'High IQ, Wrong Variables' says smart people can reason perfectly with their variables and still be poor at choosing which ones matter. ABC is useful precisely because it makes you ask what really drives the cost.
From David's concept: High IQ, Wrong Variables. This is David's opinion, alongside the standard textbook answer above.
Harder activity-based costing questions
What does a single machine-hour rate give?
$1,000,000 ÷ 10,000 hours = $100 per hour. PDA: 5,500 × $100 ÷ 3,000 ≈ $183.33; simple: 4,500 × $100 ÷ 7,000 ≈ $64.29. It ignores that PDAs drive most of the inspections.
Why does it matter if the simple phone is overcosted?
If prices are set on cost, the simple phone looks less profitable than it is and may be priced too high or dropped, while the PDA looks more profitable than it is.
Common activity-based costing questions
What are the steps in activity-based costing?
Identify the main overhead activities, group their costs into pools, pick a cost driver for each pool, calculate an activity rate, assign overhead to products based on the driver quantities they use, and divide by units to get overhead per unit.
How do you calculate the activity rate?
Divide the total cost in an activity's cost pool by the total quantity of its cost driver. For example, $400,000 of machine maintenance over 10,000 machine hours gives an activity rate of $40 per machine hour.
What is a cost driver in ABC?
A cost driver is the measure that causes or tracks an activity's cost, such as machine hours, number of setups, inspections or orders. Products that use more of a driver get assigned more of that activity's overhead.
Why is activity-based costing more accurate?
Traditional costing spreads overhead with one rate, usually labor or machine hours. ABC uses several rates tied to the activities products actually consume, so complex, low-volume products stop being undercosted and simple, high-volume ones stop being overcosted.