An activity base, also known as a cost driver or cost allocation base, is a measure used in activity-based costing (ABC) to assign overhead costs to products or services. It is a factor that drives or influences the cost of performing a specific activity. The activity base is selected based on its causal relationship with the overhead costs, meaning the activity base should be directly linked to the incurrence of the costs.
Using an appropriate activity base helps ensure that overhead costs are allocated more accurately to the products or services, providing a better understanding of the true cost of producing or delivering them.
Examples of common activity bases include:
- Direct labor hours: Overhead costs can be allocated based on the number of labor hours spent on a specific activity or product.
- Machine hours: If a process is heavily reliant on machinery, the number of machine hours can be used as an activity base to allocate costs.
- Number of units produced: In some cases, overhead costs can be allocated proportionally to the number of units produced.
- Number of setups: For production processes that require multiple setups, the number of setups can be used as an activity base.
Selecting the right activity base depends on the nature of the business and the type of costs incurred. It is crucial to choose a base that accurately reflects the relationship between the activity and the overhead costs to ensure accurate cost allocation.
Example of an Activity Base
Let’s say ABC Manufacturing Company produces two types of products: Product A and Product B. The company has identified that machine hours are the most appropriate activity base for allocating its overhead costs.
The company incurs $100,000 in overhead costs for the month, and the total machine hours used for both products are 2,000 hours. Product A consumes 1,500 machine hours, and Product B consumes 500 machine hours.
To allocate the overhead costs to each product, we will use the machine hours as the activity base. Here’s the calculation:
- Calculate the overhead cost per machine hour: Overhead Cost per Machine Hour = Total Overhead Costs / Total Machine Hours = $100,000 / 2,000 hours = $50 per machine hour
- Allocate the overhead costs to Product A: Overhead Cost for Product A = Overhead Cost per Machine Hour * Machine Hours for Product A = $50 per machine hour * 1,500 hours = $75,000
- Allocate the overhead costs to Product B: Overhead Cost for Product B = Overhead Cost per Machine Hour * Machine Hours for Product B = $50 per machine hour * 500 hours = $25,000
Using the machine hours as the activity base, ABC Manufacturing Company allocated $75,000 of overhead costs to Product A and $25,000 to Product B. This allocation method helps the company get a better understanding of the true cost of producing each product, enabling more informed pricing and production decisions.