As a business owner, understanding your costs is the first step toward increasing revenue. Traditional costing is one avenue for understanding your production costs—by allocating all overhead costs evenly across your products, you’ll get an actionable estimate of how much each product costs to make.

However, if you want to spend a bit more time doing activity-based costing—allocating overhead costs based on how each product uses them—you’ll come away with a more accurate picture of your expenses. Then, you can use activity-based costing to make more informed decisions about your business finances, and find new opportunities for growth.

What is activity-based costing (ABC)?

Activity-based costing (ABC) is an accounting method in which you break down the cost of producing products by the activities used to produce them. An activity is any task or process that uses resources to help create a product or perform a service.

In addition to how many resources you use in production, ABC costing asks where you use them, providing a more accurate view of your production spending.

How activity-based costing differs from traditional accounting

In traditional costing, you can either allocate overhead costs evenly across all products or treat all overhead as a separate expense. This keeps accounting simple and easy to assess, but can potentially distort your true costs.

For example, if you used traditional costing for your woodworking shop, you would allocate electricity (an overhead cost) evenly across all your products. In reality, building a dining table will probably use more electricity than building a jewelry box, and therefore would cost more to produce—ABC costing reveals this difference.

Think of ABC costing as adding an extra step to traditional accounting—traditional costing attaches your overhead costs to your products, while ABC costing attaches overhead costs to the activities that go into your products.

Is ABC costing right for your business?

If you run a smaller business with few offerings, the details of activity-based costing might not be all that illuminating. However, ABC costing becomes more beneficial the more complex your operations are—the more products and overhead costs you have, the more ABC costing will reveal your true costs.

ABC costing is mostly used by manufacturing businesses, but other complex business types or service-based companies can also benefit.

Benefits of activity-based costing

Here’s how ABC costing provides a more realistic breakdown of your production costs:

• Understand where your overhead costs are being used: ABC costing is more accurate than traditional costing, and provides insight into how your overhead costs are used.
• Allocate overhead costs more effectively: Traditional costing falls short if activities have unequal overhead costs, while ABC costing can highlight such areas for optimization.
• Optimize your pricing (and profit margins): By revealing your true production costs, ABC costing can help you adjust your pricing or adjust production to maintain profitability.

Challenges of activity-based costing

While ABC costing offers major benefits to certain businesses, you may face roadblocks when implementing it. Here are some examples and how to overcome them:

• Compatibility issues: If your accounting software doesn’t support ABC costing, switch to a software that supports both ABC and traditional costing (in case you decide to revert or need to use traditional costing for an external report). Train employees on the new software and method before switching all your accounting to it.
• Inaccurate reporting: All accounting requires accurate reporting, but the extra data required for ABC costing are important. Request regular updates from managers or employees to keep accurate estimates of how many hours and resources are spent on activities.
• Difficult scaling: Activity-based costing is easy enough for departments, but it becomes complex at the company-level, and especially as the company grows. While you should use accurate data, don’t obsess over having perfect data—what’s important are the inefficiencies your estimates reveal.

How to use activity-based costing for your business (with examples)

ABC costing becomes complicated fast, so start small by analyzing one product or department in your accounting software, and seek help from an accountant or bookkeeper. 

Follow the steps below for an overview of how ABC costing works. To illustrate, we’re going to use an example: Let’s say you own a brick-and-mortar store that sells three types of locally harvested honey.

1. Identify activities, cost pools, and cost drivers

Activities are actions that use resources to help create the product. Each activity has a cost pool, which is all the overhead costs you assign to that activity. A cost driver is an action that causes the cost pool to increase, such as an hour of labor worked or a bottle filled—think of a cost driver as a unit of a business expense or activity.

In our example, your business sells three products: clover, wildflower, and buckwheat honey. To start break down the true cost of producing each honey, identify these three things:

1. Activities that go into production.
2. A cost pool of overhead expenses that are associated with each activity. (In this example, the activity names refer to their full cost pool, so we can simplify.)
3. A cost driver which causes that cost pool to increase.

2. Collect data

For the previous quarter, gather your revenue, sales, and production data for all activities and cost drivers. You can collect most of these from your accounts payable platform, payment processor, and inventory management software, but you may need to ask department managers for estimates of certain activities. (Note that, when estimating hours worked on particular activities, remember to include idle or break time—your employees’ time spent on activities should not add up to their full working hours.)

In our example, your accounts payable platform reveals that this is how much you spent on each activity (for all honey production) last quarter:

• Beekeeping and harvesting: $18,000
• Filtering and bottling: $10,000
• Labeling and packaging: $5,000
• Marketing and promotion: $7,000
• Utilities and rent: $10,000

And your payment processor, inventory management software, and manager estimates produce the following stats for your cost drivers during the same quarter:

3. Calculate activity rates

Next, calculate your activity rates, or cost per unit of each cost driver, using this simple formula:

Cost pool total ÷ Cost driver = Activity rate

For your honey business, the activity rate formula looks like this:

• Beekeeping and harvesting: $18,000 ÷ 1,200 hours = $15 per hour worked
• Filtering and bottling: $10,000 ÷ 5,000 bottles = $2 per bottle produced
• Labeling and packaging: $5,000 ÷ 5,000 labels = $1 per label applied
• Marketing and promotion: $7,000 ÷ 1,000 transactions = $7 per sale transaction
• Utilities and rent: $10,000 ÷ 1,200hours = $8.33 per hour worked

4. Allocate costs

Now you have everything you need to start allocating costs. Multiply your cost driver by your activity rate to find the cost of each activity for each product:

Cost driver x Activity rate = Cost allocation

For your honey business, allocating costs looks like this:

5. Analyze results

Now that you’ve allocated costs to each product, you can more accurately assess their profitability. For each product, use these formulas to find your profit margin:

Total profit ÷ Total revenue = Profit margin

or

(Total revenue – Total cost) ÷ Total revenue = Profit margin

Here are the results of ABC costing for your honey store:

By analyzing your different products, you see that while wildflower honey is the most profitable, buckwheat honey has a higher profit margin. You might increase the price, production, or marketing of buckwheat honey to capitalize on this.

Meanwhile, beekeeping and harvesting is by far your most expensive cost driver. While this is the heart of your honey business, you may reduce associated costs by optimizing management or purchasing new equipment. Your utilities and rent are your next largest expense, so you may negotiate with your landlord to reduce this.

Apply this analysis to your own business to identify profit margins for each department or product, and see what different cost drivers are actually costing you.