How does Activity Based Costing work?

Answer 1

Activity-based costing (ABC) systems for applying overhead is a two-stage procedure.

1. The first step begins with identifying significant activities in the production of the products (that is grouping similar activities into an activity pool) and assigning a cost to that pool according to the amount of resources consumed by the activity pools.
2. In the second step:

• A cost driver (an event that results in the incurrence of cost) is identified and quantified ($$$) for eachactivity pool.
• A pool rate is computed for each activity by dividing the cost of each activity pool by the respective cost driver quantity.
• The activity cost for each product line is determined by multiplying the pool rate by the cost driver quantity incurred by each product line.
• Finally, to arrive at the activity cost per unit of product the activity cost for each product line is divided by each product line's production volume.

The advantage of this system of applying cost is that it fairly and reflectively distributes cost among products because of the incorporation of multi cost drivers. At each step of the production (activity pools), there is a cost driver that has a rate that reflects the cost of producing with that activity. Thus by the end of the production, the costs assign are reflective of the process and costs.

Hope that answers your question :)