Activity-based costing

Activity-based costing (ABC) assigns resource costs to activities, then charges the products, orders or customers that consume them. AICPA & CIMA, Activity-based costing, June 10, 2013

In the worked example, both products use 0.5 machine hour per unit. A single machine-hour rate assigns about $18.18 per unit to each. Separate setup, lot-inspection and machine-support pools assign $13 per A unit and $70 per B unit. B uses more setups and inspection lots despite lower output. Both models allocate the same $20,000.

What the model represents

Use separate drivers when support work varies independently of output or runtime. ACCA, Ken Garrett, Activity-based costing

Keep the two assignment stages distinct:

• Resource assignment: how much of a resource's cost belongs to an activity—for example, staff time spent processing orders.
• Activity assignment: how much of the activity each cost object consumes—for example, orders processed for a customer.

These stages connect resource spending to work and then to outputs; a general-ledger account alone does not describe that consumption. AICPA & CIMA, June 2013

For a simple pool, driver rate = activity cost / driver quantity; an object's assigned cost is the rate multiplied by its consumption. Keep the denominator's period and units consistent with the pool. Setup count is a batch measure, whereas machine hours can follow unit production. Choosing more pools is useful only if the resulting drivers better explain resource use. ACCA, Activity-based costing

Worked example: equal processing time, different batch demands

All figures below are invented for illustration. Assume one month, USD, two products, and only the three overhead pools shown. Direct materials and direct labor are excluded. All pool costs are assigned to the month's observed activity; this deliberately simple example makes no separate allowance for unused capacity. Assume each setup consumes equal resources, each inspected lot consumes equal resources, and machine support follows machine hours.

Product A has 1,000 units; B has 100. Each unit uses 0.5 machine hour. B's smaller runs require more setups and inspection lots despite its lower output.

For A, the calculation is 10 × $200 + 20 × $50 + 500 × $20 = $13,000. B receives the remaining $7,000. The assignments reconcile to the original $20,000.

A single machine-hour rate would instead be $20,000 / 550 hours. Without rounding the intermediate rate, it assigns $18,181.82 to A and $1,818.18 to B, or approximately $18.18 per unit for both. ABC shifts $5,181.82 from A to B; it creates no change in total spending.

This result depends on the invented drivers. If a B setup takes three times as long, counting setups equally understates B's consumption. If inspection effort follows testing duration rather than lots, the lot driver needs reconsideration. Neither result establishes a selling price, a cash saving, or a reason to discontinue B.

Capacity and time-driven ABC

Conventional ABC can become expensive to maintain when it relies on repeated employee surveys and subjective time percentages. Kaplan and Anderson's time-driven approach instead estimates the cost of supplying resource capacity and the time needed for transactions. Time equations accommodate differences between transactions, while capacity supplied and capacity used remain distinguishable. Their working paper is dated November 2003 internally, with 2004 copyright on its cover. Kaplan and Anderson, HBS working paper 04-045

As a separate invented example, $12,000 of monthly resource cost divided by 1,000 hours of practical capacity gives $12/hour. If modeled work uses 800 hours, $9,600 is assigned to that work and $2,400 represents unused supplied capacity. Dividing by only the 800 used hours would give $15/hour and assign the whole cost to current work. These are different denominator choices, not interchangeable estimates. Practical capacity must reflect the resource and operating conditions; the 1,000 hours here is an assumption, not a benchmark. The distinction follows the capacity treatment in Kaplan and Anderson's original paper.

Using the results responsibly

ABC supplies cost information; activity-based management (ABM) uses it to change processes, support decisions, and assess performance. APQC's October 2026 guidance emphasizes consistent activity definitions, reliable data, leadership support, and maintainable reporting. Estimated drivers can distort results, and a model built for one use may not justify its ongoing cost. APQC, What Is Activity-Based Costing?, October 2026

For a usable implementation, define the decision and cost objects before gathering detail. Record the accounting period, currency, included resources, assignment basis, driver units, and capacity denominator. Reconcile assigned costs plus explicitly unassigned amounts to the included resource total. Compare modeled consumption with operational records, investigate exceptions, and refresh drivers when processes change. These are practical ways to apply APQC's emphasis on fact-based data and sustainable systems. APQC

An allocated cost is not automatically a relevant cost for a particular decision. Reassigning existing fixed overhead produces no cash-flow change if the underlying spending stays the same. A product withdrawal or outsourcing proposal needs its own analysis of changed future cash flows, avoidable commitments, and opportunities forgone. Additional fixed costs can be relevant when the decision causes them. ACCA, Relevant costs

For the worked example, reducing B's setup count might release capacity without reducing payroll or equipment expense that month. Whether that capacity can support other profitable work or allow a later spending reduction is a separate operational question. Use ABC to identify the resource demand to investigate, then evaluate the actual alternatives.

Related: Cost structure and cost bases.