Activity-based costing (ABC) is one of the “hottest” areas in managerial costing.

Activity-based costing (ABC) is one of the “hottest” areas in managerial costing. As you have learned to date, there are many different ways that a company can allocate overhead costs to various projects. ABC is regarded as one of the most effective measures to allocate this overhead. Though it is considered highly effective, many businesses are unable to utilize it due to the high setup cost, which has declined over the years due to improved technology. As a professional in a management role, it is highly probable that you will encounter the use, or proposed use of ABC in a management setting.

Within the ABC system, there are seven steps:

Identify the cost objects. Cost objects are the products being produced.

The direct costs need to be identified. The direct costs include direct materials and direct labor associated with creating or manufacturing the product.

It is necessary to identify the activity drivers—those significant activities that create value of the product and set the allocation base. The allocation base is similar to that used under job costing such as direct labor hours or machine hours. For example, if inspections or set-up time are considered activity drivers or significant activities within the production process then the allocation base maybe direct labor hours involved in step up or the set-up hours.

Identify all the indirect costs. The total indirect cost or manufacturing overhead is broken down into cost pools based on the significant activities identified. For example, previously set-up was used as a significant activity. All the cost related to the set-up activity would be included in its related cost pool.

Calculate an overhead rate for each base or activity identified. This is similar to what was done under job costing system, where you have calculated a rate that would be applied in our cost allocation. The key aspect to note is that there will be more than one rate. There will be several rates based on the number of activities identified in the process.

Calculate the indirect costs for the allocation. This is similar to what was done in our job costing system, but instead of having one rate and one allocation, there may be several based on the number of activities identified.

Compute the total costs. The total costs are the combination of direct material and direct labor as well as indirect costs or manufacturing overhead.