While a simple cost system using just one cost driver (machine hours) may result in accurate financial statements, it often fails to provide the true cost of individual products that vary in complexity. For example, one product might require very few machine hours but will require many hours of special handling. The costs assigned on the basis of machine hours alone will be too low in relationship to the true cost of manufacturing this product. Another product might require many machine hours but no other activities. This product’s cost will be overstated because the rate assigned via the machine hours will include an amount for other activities that generally occur for the other products manufactured.

A cost system developed for inventory valuation is limited to the cost of direct materials, direct labor, and manufacturing overhead. The total cost of providing products to a customer will also include nonmanufacturing expenses. One customer might require a company to incur additional selling, delivering, storing, and administrative expenses. Another customer might not require any of those activities and their related expenses.

Activity based costing attempts to calculate the true cost of a product and customer by assigning costs and expenses based on their root causes. Because there are many root causes, the company will assign costs based on many cost drivers. This results in more accuracy for the cost and expense of a specific product for a specific customer than simply spreading the manufacturing costs on the basis of one cost driver such as machine hours.

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In reality there are many drivers of the factory overhead: machine setups, unique inspections, special handling, special storage, and so on. The more diversity in products and/or in customer demands, the bigger the problem of allocating all the costs of these various activities via only one activity such as the production machine’s hours.

Under the traditional method, the costs of performing all of the diverse activities will be contained in one cost pool and will be divided by the number of production machine hours. This results is one average rate that is applied to all products regardless of the number of activities and the complexity of those activities. Since the cost of many of the diverse activities do not correlate at all with the number of production machine hours, the resulting allocations are misleading.

Activity-based costing is intended to overcome the weakness of the traditional method by having various pools of costs and then allocating each pool’s costs on the basis of its root cause.

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In the case of a manufacturer, some products may require special engineering, sophisticated testing, unique storage arrangements, and are low-volume items. Other products might be high-volume items that run continuously and require no special attention. In other words, some products require lots of activities (engineering, testing, storing, many machine setups, and running the production machine), while some products require just one activity–running the production machine. Under activity based costing, the products that require the activities mentioned above will be assigned the costs of engineering, testing, storing, setups, and producing activities. The products that run continuously will not be assigned costs for engineering, etc. These products will only be assigned the cost of the production activity. (If activities were not considered, and all costs were allocated solely on machine hours, the high-volume, easy-to-manufacture products would be assigned an enormous amount of overhead, and the low-volume, activity-intensive products would be assigned too little overhead cost.)

Activity based costing is useful for service businesses as well as manufacturers. The process of identifying and determining the cost of activities can lead to improvements in a company’s operations.

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By using only machine hours to allocate the manufacturing overhead to products, it is implying that the machine hours are the underlying cause of the factory overhead. Traditionally, that may have been reasonable or at least sufficient for the company’s external financial statements. However, in recent decades the manufacturing overhead has been driven or caused by many other factors. For example, some customers are likely to demand additional manufacturing operations for their diverse products. Other customers simply want great quantities of uniform products.

If a manufacturer wants to know the true cost to produce specific products for specific customers, the traditional method of cost accounting is inadequate. Activity based costing (ABC) was developed to overcome the shortcomings of the traditional method. Instead of just one cost driver such as machine hours, ABC will use many cost drivers to allocate a manufacturer’s indirect costs. A few of the cost drivers that would be used under ABC include the number of machine setups, the pounds of material purchased or used, the number of engineering change orders, the number of machine hours, and so on.

The overhead that we are referring to is not limited to manufacturing overhead. Some customers also demand activities that drive up the administrative overhead and the selling expenses. The idea behind ABC is that the customers and products that are causing the manufacturing and administrative overheads to occur should be assigned those costs. If there is the diversity of products and customers (some require costly activities and some don’t), it isn’t fair to simply spread all of the cost of all of the activities to all of the products and customers on the basis of just one activity, such as machining hours. The non-machining overhead costs should not be assigned to products and customers that don’t require the other activities. The products and customers that demand the other activities should be assigned the cost of the other activities.

Again, if your company has little variation among products and customers, and most of its overheads are related to just one activity, such as machining hours, using machine hours to allocate the overhead costs is probably satisfactory. However, if you manufacture products that are not uniform in the attention and activities necesary to serve the customer, you should learn more about activity-based costing.

Learn more about Activity Based Costing.