Activity Based Costing: Definition, Functions & Applications

In a company, product pricing is a decision that must be done carefully and even difficult. For this reason, an accounting method called activity based costing emerged. Where, activity based costing is a method of calculating total production costs. 

Activity based costing is a complex subject. Therefore, you need to learn some of the basics so you don't miscalculate them. Let's see further discussion below. 

What is Activity Based Costing?

Activity-based costing is an accounting system to find out how much the total activity cost required to make a product. 

The system with the abbreviation ABC calculates all costs of activities that enter production, such as the cost of processing raw materials. 

The definition of activity based costing according to Cooper and Kalpan is a system for calculating the costs of individual activities and assigning costs to cost objects as examples of activity-based goods and services carried out to produce each product and service. 

Another system commonly used in the business world is COGS or cost of goods sold to calculate the total cost of making a product. 

However, the following system does not involve indirect budgets such as overhead costs but only takes into account direct funds. 

Some business actors take the overhead costs of each production of their goods and divide it evenly. 

However, this COGS will not be accurate for accounting purpose for those businesses whose products have large disparities in manufacturing costs. 

Therefore, the calculation of each incoming activity from direct costs and indirect costs in this ABC system provides information about the total amount of budget required for each product will be different.

Not only that, this method helps to evaluate whether there are indirect costs that can be reduced. 

Both of these knowledge will then be useful in setting a competitive market price. 

For example, your business produces trendy t-shirts. T-shirt A costs more because the decoration is more complicated than T-shirt  B. 

The activity based costing system is the right method to use because calculating costs based on activity and T-shirt A requires more funds than T-shirt B. 

Activity Based Costing Components 

Activity based costing also consists of several components. The following is a description of these components.

1. Activities 

The activity component is a work unit. For example, if you visit a cafe to eat, the waitress at the cafe will carry out the following activities:

  • Provide cafe menu
  • Receive your order
  • Sending orders to the kitchen
  • Serving food and drink orders
  • Counting and billing 
  • Receive money and give change  

Each of the above activities has its own costs. The cost is determined by the organization taking into account the resources and drivers of these resources. 

2. Resources drivers

Another component of activity based costing is resources drivers. 

This element is the core of the resource-to-activity process. The definition of resource drivers itself is a benchmark for the amount of resources required by an activity.

3. Resources

Resources in activity based costing are economic elements used to complete an activity. 

These resources are a forum for the organization to budget funds and as a category of costs to be recorded. 

Examples of resources are salaries and materials. Salaries are given to employees to complete certain production activities and materials to form a product. 

Not only that, resources can include costs for inspections, repairs, rent, utilities, insurance, depreciation, and supplies.

4. Cost objects

Another component of activity based costing is cost objects. The term with another name for this cost object can be in the form of products, contracts, customers, projects, or other activities and work units that want to have their own measurements. The budget of a product or service is a general form of a cost object. 

The essential component for calculating activity objects to cost objects in activity based costing is the activity driver. 

5. Activities drivers

Activities drivers in activity based costing are activity cost drivers. Similar in principle to resources drivers, activity drivers assign a cost object to an activity. 

This term is given the understanding as a parameter of the intensity and number of requests and is pegged to an activity to be given a cost value. 

Activities drivers can also be seen as all activities that generate costs. The cost drivers in activity based costing are elements such as volume or high activity and are able to have a direct impact on the funding needs of an activity (over a certain period of time).

To clarify what activity drivers are, here are some examples of trading activities in a business:

  • Total shipping orders for shipping department
  • Order quantity received for receiving department
  • The size of the purchase order to budget the operations of the purchasing department 
  • The value of the material or ingredients in a product 
  • Total inspection 
  • Changed schedule quantity 
  • Total employees
  • The quantity of units that have been removed 
  • Total share
  • Number of customer orders processed 
  • Quantity of material handling time
  • Direct working hours 

Functions & Benefits of Activity Based Costing 

If a company implements an activity based costing system properly, it will get many benefits. The following are some of the functions and benefits of activity based costing:

  • The function of activity based costing is to guide the company's future decisions 
  • ABC system helps to apply prices that are more suitable and superior to competitors
  • The benefit of activity based costing lies in its ability to give stakeholders an idea of which costs can be optimized
  • Performing an analysis on products that have passed the activity based costing system is a wise thing because of the opportunity to improve the production process of goods or services to achieve the best quality at the best price

Characteristics of Activity Based Costing 

The activity based costing system is an accounting method that does not escape several characteristics for companies to fulfill to meet this definition. 

Here are some characteristics of activity based costing:

1. Business has a high diversity of goods

The first characteristics of a company that implements activity based costing is high production diversity, including a variety of products and production lines.

This is why businesses need separate calculations for each product where the ABC system can help.

2. Low calculation budget 

In addition, the budget from measuring using the ABC system must be lower than the benefits.

If, on the other hand, the costs of practicing the ABC system are higher than the profits, the company will suffer a loss. 

3. High level of competition 

If the product in your company has a high level of competition, what is usually done is to increase the competitive value of a product to be able to reach a wider market. This requires the more accurate calculations offered by the ABC system.