How to Design an Activity-Based Costing System

By Kenneth Boyd, Lita Epstein, Mark P. Holtzman, Frimette Kass-Shraibman, Maire Loughran, Vijay S. Sampath, John A. Tracy, Tage C. Tracy, Jill Gilbert Welytok

If your activity-based accounting (ABC) system is well designed, you allocate costs more precisely. You carefully separate costs between direct costs and indirect costs. You also consider the specific activities that drive the indirect costs higher. Finally, the indirect costs are allocated to the activities that cause those costs to be incurred.

Refining your approach

ABC is a refined costing system, or a more specific way to assign costs to cost objects. The system avoids using big, generic categories, such as splitting a cost evenly between divisions. Instead, it allocates indirect costs to the activities that generate those costs. The result is likely to be more accurate costing and product pricing.

The refined costing system requires you to perform the following three tasks:

  • Direct cost tracing: Review your direct costs and categorize more costs as direct costs, if possible.

  • Cost pools: Review cost pools and create more pools, if necessary.

  • Cost-allocation bases: Decide on cost-allocation bases by using cause-and-effect criteria.

Direct costs are traced to cost objects. As a result, the amount of cost is fairly easy to determine. For example, determining the amount of leather used to make the leather handbags is easy.

Cost pools should be homogeneous; that is, each of the costs has the same cost allocation base. The costs have a similar cause-and-effect relationship. Therefore, if you have more than one allocation base, you should have more than one cost pool.

A good example is a cost pool combining vehicle depreciation, repair and maintenance, and fuel costs. The costs all increase when your vehicles drive more miles. The cost allocation base should be mileage, and you simply allocate a dollar amount of indirect cost per mile driven.

Grouping costs by using a cost hierarchy

A cost hierarchy groups costs into cost pools based on cost drivers or cost allocation bases. A cost hierarchy has levels, which explain how broadly you look at costs and activities. Here are levels you may use in a cost hierarchy:

  • Unit-level costs are cost activities performed on an individual unit, whether a product or service. If you make blue jeans, your unit is one pair of jeans. An individual tax return is a unit, if you prepare tax returns for clients.

  • Batch-level costs are cost activities that generate costs at the batch level. For example, when an automobile plant changes from one car model to another, it’s changing batches and incurring setup costs. The plant is “retooling,” which may include moving machinery, and certainly includes changing out the dies and reprogramming the welding robots.

  • Customer-level costs are cost activities generated for one customer. If you’re remodeling a kitchen, your labor costs, materials used, and overhead costs incurred for a specific customer are all customer-level costs. Customer-level costs may include multiple orders from the same client.

  • Product-sustaining costs are cost activities that support a particular product or service line, regardless of the number of units produced. A product-sustaining cost extends the life of a product; technology products are good examples. To stay relevant with customers, software companies come out with endless new versions of software.

    Extending a product’s life is supposed to keep customers buying it. Design costs can be product-sustaining costs. To keep the technology product current, you change the design. You can allocate product-sustaining costs to a product or to an entire product line (sometime called a “product family” in high tech).

  • Facility-sustaining costs are cost activities that support the overall company, such as legal and accounting activities. The rent, insurance, and maintenance on the company’s building are facility-sustaining costs, because the building is essential to keeping the entire company running. The costs should be allocated over the entire company. Companies with multiple buildings sometimes cost allocate for each building to see whether a building is too expensive to occupy.

If you use a fine-enough granularity, you can get really precise costing. On the other hand, too much granularity will make you crazy. The financial benefit of precise costing should be greater than the time and expense to track the cost information. The financial benefit is more accurate product costs and more precise profit calculations.