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Activity-based costing is a system of costing ‘that recognizes that costs are incurred by each activity that takes place within an organization and that products (or customers) should bear costs according to the activities they use. Cost drivers are identified, together with the appropriate activity cost pools, which are used to charge cost to products
The implementation of an activity-based costing system involves four main steps:
Identify the main activities in the organization and classify them into activity centres if there are a large number of different activities. An activity centre is an identifiable unit of the organization that performs an operation that uses resources.
Identify the cost drivers associated with each activity centre. A cost driver is ‘any factor such as number of units, number of transactions, or duration of transactions that drives the costs arising from a particular activity. When such factors can be clearly identified and measured, they will be used as a basis for allocating costs to cost objects.
Calculate the cost driver rate, which is the cost per unit of activity. For example, in purchasing it would be the cost per order placed.
Assign costs to the products by multiplying the cost driver rate by the volume of the cost driver units consumed by the product. With purchasing, the cost driver rate will be calculated on the basis of orders placed.
