The Seven Steps of Activity-Based Costing

Lesson Transcript
Instructor: Christian George

Christian has a PhD in Business Management and an MA in Accounting & Financial Management

Activity-based costing takes into account the activities needed to complete products, including the associated costs of each activity. Discover the seven steps of activity-based costing and learn how it is used in organizations. Updated: 12/15/2021

The Move to Activity-Based Costing

The world of manufacturing costs has greatly improved over the last 20 years as companies have moved away from traditional product costing to a more modern and realistic product costing method: activity-based costing (ABC). Activity-based costing is a costing method based on the actual costs to design, manufacture, and sell a product. The company assigns overhead costs, which include direct materials, direct labor, and manufacturing overhead, and indirect overhead that is associated with the manufacturing of the product. ABC also ensures that per item manufacturing costs are more correct.

For example, advertising for a computer made by XYZ, Inc. is an activity attached to the computer. Because of that, it is figured into the cost of the computer, along with the manufacturing costs (direct materials, direct labor, and manufacturing overhead). These three categories of manufacturing costs make up the traditional method of product costing. This method is no longer used because ABC allows companies to more accurately determine the true cost of a product.

ABC allows companies to more accurately determine what the true cost of a product is. This then allows them to correctly price the product to the customer. Proper management of money and knowing the exact amount of that money used to manufacture a product helps the company to remain profitable.

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  • 0:05 The Move to…
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The Seven Steps of ABC

There are seven steps used by companies as they progress through the costing process method of activity-based costing.

1. Identify the products that costs will be defined by.

XYZ, Inc. makes a telephone wire that is used in residential and commercial construction projects to supply data communication services to customers. XYZ is introducing a newer, higher tech version of the telephone wire, Category 6, to its customers and needs to determine how much the wire will cost and how much to charge for it. This new wire, which we will call Cat 6, is the cost object. It is the object that needs a cost assigned to it.

2. Figure out the direct costs of the product.

The direct costs of a product are the costs that can be directly attributed to the manufacturing of a product. As stated earlier, they are:

  • Direct materials (raw materials and other materials used in the manufacturing process)
  • Direct labor (the labor costs of the employees manufacturing the product)
  • Manufacturing overhead (the overhead attached to the manufacturing process, such as electricity at the factory that makes the telephone wire)

The direct costs to manufacture a batch of the Cat 6 are listed in the chart below:

Direct Cost Category Amount
Direct Materials $200
Direct Labor $500
Manufacturing Overhead $800

Total $1,500

3. Select the activities to use for assigning indirect costs to the products through using a cost-allocation base.

The activities that relate to indirect costs to manufacture a batch of Cat 6 and their cost-allocation bases are listed in the following chart. For this lesson, we will simplify the indirect costs activities as advertising and marketing, administrative, and sales, which you can see in the table below:

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