Activity based costing is a costing method that assigns overhead in two stages. Costs are first grouped into pools around the activities that cause them. Each cost object, meaning whatever is being costed, whether a product, a service, an engagement or a client, is then charged for the activity it actually consumed, at a rate per unit of that activity’s cost driver. It is commonly written activity-based costing and abbreviated ABC, and what makes it activity based is that every pool carries its own driver and its own rate, while the traditional method sets a single rate for the whole operation, or one rate per department, on a volume base such as direct labor hours.
The Three Terms the Method Runs On
A cost pool is an accumulation of costs that are incurred during the production of the activities included in that pool. A cost driver is the activity that is the reason for the increase or decrease of another cost, illustrated with labor hours incurred, labor costs paid, amounts of materials used in production, units produced, or any other activity that has a cause-and-effect relationship with incurred costs (OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, Chapter 6 key terms). The activity rate is the third, and it is a pool’s cost divided by the total volume of that pool’s driver.
Stage 1 resources -> activity cost pools
Stage 2 activity rate = pool cost / total cost driver volume
overhead applied = activity rate x driver units the cost object consumedOpenStax names both halves: the steps involve two major processes, first allocating overhead costs to the various activities to get a cost per activity, and then allocating the cost per activity to each product based on that product’s usage of the activities (OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, section 6.3). Which costs belong in the pool at all is the indirect-cost question worked through in overhead, and the act of assignment itself is allocation.
A Worked Example
Say a firm’s entire overhead pool for a year serves two clients, and the firm wants to know what each one costs to serve. One rate over billable hours answers one way, and two activity pools answer another.
Overhead pool for the year $180,000
Transaction processing pool $120,000
Client contact pool $60,000
Client A Client B Total
Billable hours 1,500 4,500 6,000
Transactions processed 90,000 30,000 120,000
Client contacts 300 900 1,200
Single blended rate
Whole firm $180,000 / 6,000 billable hours = $30.00 per billable hour
Client A 1,500 hours x $30.00 = $45,000
Client B 4,500 hours x $30.00 = $135,000
Activity rates
Transaction pool $120,000 / 120,000 transactions = $1.00 per transaction
Client contact pool $60,000 / 1,200 contacts = $50.00 per contact
Client A (90,000 transactions x $1.00) + (300 contacts x $50.00) = $105,000
Client B (30,000 transactions x $1.00) + (900 contacts x $50.00) = $75,000Both methods spread the same pool and both spread all of it. The blended rate put most of it on the client with the most billable hours, while the activity rates put most of it on the client whose work generated the transaction volume.
When Splitting a Pool Is Worth It
The premise has a rule form. Federal cost accounting standards, which bind covered government contractors rather than every business, require indirect costs to be accumulated in indirect cost pools which are homogeneous and allocated to cost objectives in reasonable proportion to the beneficial or causal relationship of the pooled costs to cost objectives, and they define homogeneous partly by outcome, since a pool is also homogeneous if allocating its activities separately would not produce a materially different allocation (48 CFR 9904.418-40(b) and (c) and 48 CFR 9904.418-50(b)(1)).
That is the test worth borrowing. A finer set of pools earns its cost only where the finer answer differs materially from the blended one.
What This Looks Like Inside a CPA Firm
The natural cost objects are engagements and clients, and the tax rules describe the same shape when they define a specific identification method as one that traces costs to a cost objective, such as a function, department, activity, or product, on the basis of a cause and effect or other reasonable relationship (Treasury Regulation 1.263A-1(f)(2)). The drivers that fit a firm are counts of the work itself: returns prepared, transactions processed, reconciliations completed, contacts with the client. A single rate spread over total billable hours cannot see any of them, so a client whose cost sits in volume rather than in hours looks cheaper to serve than it is. Which internal reports this feeds belongs to managerial accounting.
What Activity Based Costing Is Confused With
Reducing Overhead
The method allocates overhead more finely; it does not remove any of it. The pool total is identical before and after, and only the shares move, which is why a costing change on its own never shows up as a saving.
A Financial Reporting or Tax Method
It is an internal choice, and choosing it does not by itself change what the outside computations require. For a client with inventory, the allocation of fixed production overheads to the costs of conversion is still based on the normal capacity of the production facilities (Accounting Research Bulletin No. 43, Chapter 4, paragraph 5, as amended by FASB Statement No. 151). On the return, a taxpayer may use one of the methods the regulation names or any other reasonable method, and reasonable is tested on three conditions: the total capitalized does not differ significantly from another permissible method, the method is applied consistently, and it is not used to circumvent the simplified methods or the principles of section 263A (Treasury Regulation 1.263A-1(f)(4)). A firm running activity based costing internally still reconciles to both.
A Single Predetermined Rate
A plant-wide rate divides a single pool by a single base in exactly the way an activity rate divides a pool by its driver, and a departmental rate does the same once per department. What activity based costing changes is how the pools are drawn and what drives each one, not the arithmetic. Setting a predetermined rate, choosing its base, and disposing of whatever it over-applies or under-applies at period end are covered in costing overheads.
Common Questions
A purchasing pool charged out on purchase requisitions and an inspection pool charged out on inspection hours are the textbook pair, because a product needing many small orders consumes purchasing effort that its labor hours never reveal (OpenStax, Principles of Accounting, Volume 2: Managerial Accounting, section 6.3). In a firm the equivalent is a client contact pool charged out on the number of contacts.
There is no single figure to calculate. You work out one rate per pool, dividing that pool’s cost by the total volume of that pool’s own driver, then apply each rate to the driver units each cost object consumed. The denominator is where it usually goes wrong, because it is the total driver volume for that one pool and not the total volume of everything the business does.
The gain is accuracy where a pool holds activities that behave differently from each other. The cost is the measurement itself, since every driver has to be counted for every cost object, period after period. Where the pools a firm already uses would not produce a materially different answer, the finer system buys nothing.
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