The activity based costing approach differs from traditional costing methods in the way that it uses activities that receive their costs from consuming resources. Activity Based Costing is a way of costing variety and complexity in production, not just linking costs between resources and physical volumes produced. Using Activity Based Costing provides a more accurate calculation of the real cost of the product, identifies break-even points, ranks parts from money makers to money losers, etc.
The basic approach is to connect system activities to resources and cost centers. The activities are attributed to inventory parts. It is possible to attribute costs to certain products that are more complex and varied than the standard product produced, by adding at least one activity directly to that product.
Instead of arbitrarily raising the machine cost or creating special, virtual work centers for the complex products, you can assign activities with drivers (e.g., number of setups and number of setup hours) to the specific products in question. Products that tend to need more setup time, engineering, or other preparations would thus carry more of the overhead costs than the standard product.
The following section describes the work flow for setting up an Activity Based Costing system. The work flow is a suggested way of working with activity based costing; naturally, you can, if you want to, devise your own way of working with it.
It is the activities within the company that consume resources. Even though the number of activities varies from company to company, try to find the 10-15 most important and frequently used activities within your company.
The cost centers are defined, together with a budgeted cost, per time period. The time period can be as short as a daily period, but the suggested time period is for a quarter, semi-annual, or annual cost definition.
An activity must be linked to a cost center in order to be able to pass costs down to the final carrier of the cost, i.e., the parts. For this purpose, you define a factor by which the activity consumes costs from the cost center. An activity can consume costs from several different cost centers.
This is where the activity cost driver rate is calculated. The activity cost driver rate is the rate of cost for each activity. The rate obtained from the cost center divided by the estimated use of the activity cost driver comprises the cost that the activity carries to any associated part.
When an activity is created, a bucket with the same identity is created. The activity and bucket bear a one-to-one relationship. They are treated the same way, regardless of whether the bucket content comes from activities or from elements.
An activity cost driver is the Activity Based Costing equivalent of a cost element. The distinction between the two lies within the nature of the driver and the assigned amount.
An activity cost driver has a source within the system. It is a quantitative measure of the output of an activity. Each time a cost driver is executed, the costs from the connected activity are attributed to the part(s) to which it is connected.
Examples of activity cost drivers are the number of moves, the number of issues, the number of receipts, and the number of setups. Examples of cost elements are the number of setup hours, the number of machine hours, and the number of labor hours.
Another distinction between the activity cost driver and the cost element is that the number of issues and number of receipts, although traceable within the system, are not set up by the user in the bill of material or the routings. The numbers of these activities must be set up within the costing system.
The system supports both transaction drivers and duration drivers. A transaction driver counts the frequency with which the activity occurs. Transaction drivers can be used when all outputs have an equal demand on the activity. Examples of transaction drivers are the number of setups and the number of issues.
The duration drivers represent the amount of time required to perform an activity. The time required for an activity can vary among different inventory parts. Examples of duration drivers are labor setup hours and machine runtime hours.
The system creates a set of default activity cost drivers when a site is created:
| Value | Description |
| 110 | Number of issues |
| 120 | Weight per unit |
| 210 | Number of labor setups |
| 220 | Number of labor operations |
| 230 | Labor setup hours |
| 240 | Labor runtime factor |
| 310 | Number of machine setups |
| 320 | Number of machine operations |
| 330 | Machine setup hours |
| 340 | Machine runtime hours |
| 410 | Number of customer orders |
| 420 | Number of units produced |
| 430 | Number of components |
| 440 | Number of parts |
| 450 | Number of products |
| 460 | Cost of Unit Produced |
| 470 | Number of Purchase Orders |
| 520 | Number of Receipts |