Compared to the Full Cost principle, Activity Based Costing (ABC Costing) attempts to allocate indirect product costs (overheads) more directly to the individual product and service. ABC costing is also using an allocation key systematic, however the keys are established as activities rather than e.g. flat percentages or direct hours.

The systematic of ABC costing will allow companies to allocate indirect cost to their products and services more accurately, and to more reliably analyze actualized product costs. The rationale is that seemingly equal products can have totally different levels of resource consumption in the entire value chain that cannot be analyzed properly using a full cost method, in which costs are allocated to products based on allocation keys not necessarily variable with real consumption of indirect cost and resources of individual products or services.

The case presented by Robert S. Kaplan called “Classic Pen Co.: Developing an ABC Model”, is illustrating more precisely the problems using full cost principles, and is advocating the usability of ABC costing when having problems costing products and services appropriately.

The systematic of the Activity Based Costing is presented below.

Identify the resources to be distributed to products, services or customers

What is the total pool of indirect cost that needs to be absorbed by the company’s products or services? The task is here to budget the expected level of costs generated in a given period, if you want to price future products, or to identify the total pool of actualized costs, if you want to evaluate actualized product costs.

Total Resource Pool = All indirect cost generated

Identify performed activities and the price pr. activity.

Next step is to understand the different activities performed in the internal value chain of the company, and price the activities. The total resource pool is distributed to activities using a resource driver, which could be an allocation or, more optimally, a directly analyzed split of cost into a given activity.

All indirect Cost = $1.000.000

Split of all cost into activities e.g. production floor:

Blue Collar Wage for indirect workers $150.000
Depreciation of Machinery $40.000
Work Clothes $2.000
Rent for Trucks $5.000

This will leave the total estimated indirect cost for the production floor at $197.000.

The next step is to identify the expected activity driver and the expected amount of activities performed. In this fictive example it could be set-ups of production, if this is the prime driver of the indirect cost in the production floor.

Cost pr. activity = $197.000 / amount of set-ups

Cost pr. activity = $197.000 / 2.500

Cost pr. activity = $78,8

Allocate cost to the cost object.

Finally, the cost needs to be allocated to a specific cost driver e.g. a product.

The calculation could look like this for 2 similar products, with different complexities in production set-up.

Product 1

Direct Material = $200
Direct Labor = $50
Indirect Labor = (5*set-ups) $394

Total = $644

Product 2

Direct Material = $200
Direct Labor = $50
Indirect Labor (8*set-ups) = $630.4

Total = $880.4

This simple example illustrates how allocations of indirect costs to e.g. products function via the ABC costing principle. If the full cost principle would have been used, product 1 and product 2 would potentially have been costed with the same price.