Activity Based Costing

Activity-based costing (ABC) is an accounting method that provides a more definitive understanding than traditional accounting methods of the costs associated with processes and resource allocation. ABC determines the actual costs of process that are employed in a business system in order to produce goods and services. The ABC method focuses on the resources that are consumed by activities in order to produce and deliver goods and services to the customer. The underlying assumption of ABC is that the cost objects produced by the firm, which can be either a good or a service, creates a demand for an activity that consumes resources, with the consumption of resources producing costs. From this perspective, the cost objects are the reasons that the firm engages in activities, with the activities as the processes that result in work and consume resources. The ABC method analyzes costs from the position of how much a specific activity costs the firm and measures the level of cost by the amount of resources that the activity consumes.
The first step in the ABC process is to identify the costs of the activities and resources that are used in producing the cost object, which is often accomplished by examining ledger entries regarding the activity in order to compile cost data.  Cost drivers are then assigned to the specific activity or process. The cost drivers are derived from cost pools, which are costs such as labor hours or machine hours that behave in a similar way. For example, the cost drivers of a production process can include portions of the labor hour and machine hour cost pools, with the percentage of the cost pool allocated to the specific cost object dependant on the activity rate of the process. A product that requires two labor hours to produce would have twice the allocation from the labor hour cost pool as a product that required only one hour for production.