What is activity-based costing? Definition and examples

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When running a business, profits are everything.

To achieve your entrepreneurial goals, you will need to order your calculations in an organized and efficient way to ensure that your numbers are in the direction you want to go. Activity costing is a useful metric you can use to quantify the costs associated with producing the products and services that are the backbone of your business.

This article explains how to calculate your cost per activity as well as the advantages and disadvantages of activity-based costing, one of many accounting terms that can be used to help keep your business finances in order.

To calculate the cost per activity, a few variables need to be identified.

First, you must label all the activities necessary to create your product or service. Once these have been identified, you will need to sort them according to the costs associated with producing each product or service. Below, we’ll go over the steps you can use to calculate the cost per activity of producing your products and services using activity-based costing.

How to use activity-based costing

There is a simple three-step method to calculate cost per activity using activity costing.

1. Sort your overhead costs by activity

The first step in calculating cost per activity using activity-based costing is to sort all the money you spend on your products and services, also known as overhead, into categories. These categories are called cost pools, which will be identified by the activity that consumes the costs.

An example of a cost pool could be the cost of a maintenance service or a quality control service.

Essentially, you start sorting through all the costs in your business by determining which costs come from which department or type of activity.

2. Identify which activity generates each cost

Next, you’ll want to be a little more specific in how you sort out those costs when determining the cost drivers.

For example, costs for a maintenance service can come from a specific number of leaks or plumbing issues. The costs of a quality control department can come from issues requiring a higher number of inspections and in-depth meetings.

For this step, you will need a barometer of what activities each department in your company is responsible for and how many of those activities were carried out by each department in the given time period for which you are calculating the unit cost.

3. Calculate

Finally, you’ll calculate the cost of each individual cost factor, such as repairs or inspections, to your business. You can determine this by dividing the cost pool by the number of cost drivers for each department.

For example, you would divide the cost pool for a maintenance service during a given period by the number of repairs performed during that same given period.

This calculation gives your cost per activity.

Advantages of activity-based costing

Costing by activity helps a company sort out its costs in a more efficient and orderly manner by requiring cost segregation by activity. Essentially, it offers clarity to a sea of ​​costs that can sometimes seem indirect and uncaused.

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When tracking costs incurred by your business, you will want to have a system in place to identify cost sources as easily as possible. Activity-based costing provides this structure and allows a business to access a more accurate measure of the cost of each unit it produces, whether material or service.

Disadvantages of activity-based costing

There are, however, some drawbacks to using activity-based costing. Activity-based costing is generally used in the manufacturing sector. As industries and workflows have evolved, the amount of overhead (costs associated with manufacturing individual products) has become a larger proportion of total costs.

Workflows have become more automated through advancements in technology and machine learning instead of relying on manpower. Additionally, products have become more unique and specialized as markets have become more saturated. If these overheads make up the majority of a company’s costs, activity-based costing may be of limited benefit.

Get the cost

Now that we’ve covered the basics of activity-based costing, you can go ahead and implement it in your company’s chart of accounts. And if you’re looking for automated help with your business accounting needs, be sure to check out G2’s guide to the best accounting software.

See the top rated accounting software →

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