Then, once the company has identified its available resources and resource-consuming activities, it will assign the cost of resources to the activities that consume those resources. To accomplish that, the company will choose resource consumption cost drivers. For example, for batch-level activities the resource consumption cost driver is the number of setups; for general maintenance activities – the number of square feet; for machine maintenance or repair activities – the number of machine hours; for labor-intensive activities (e.g. product testing, engineering) – the number of labor hours, etc. For instance, if a machine set-ups activity requires 0.5 machine hours, and each machine hour costs $20, then, the machine set-ups activity costs $10 ($20 x 0.5).

The cost of resources consumed by an activity can be determined through direct tracing or estimation. For example, Friends Company, a manufacturer of valves, can directly trace the cost of electricity consumed by manufacturing machines by reading the power meter attached to the machines. When it is impossible to directly trace the cost of resources to activities, a factory supervisor and department managers will estimate the amount of effort (or time) spent by employees on performing such an activity.

By assigning cost of resources to the activities consuming those resources, a company can determine the cost of each activity. Using this information, the company can determine the cost of the factory’s output.

Finally, the company will assign cost of activities to cost objects based on activity consumption cost drivers. Examples of cost objects are: individual products or services, job orders, projects, customers, business units, etc. Activity-consumption drivers measure amount of activity consumed by a cost object. 

For example, to assign a cost of inspection activities, a number of inspection hours (or reports) consumed by a cost object will be used as an activity-consumption driver. If an hour of inspection activities costs $15, and a cost object consumes two hours of inspection activities, then the cost object will be allocated $30 for inspection activities.

Using the example mentioned in an earlier section (i.e. if a machine set-ups activity requires 0.5 machine hours, and each machine hour costs $20, then the machine set-ups activity costs $10): if a cost object requires three machine set-ups, and the machine set-ups activity costs $10, then the cost object will be assigned $30.

Examples of activity consumption cost drivers are: direct labor hours, machine hours, number of set-ups, purchase orders, inspection and receiving reports, etc.

Overall, steps for implementing activity-based costing are summarized below:

Illustration 3: Steps in developing an activity-based costing (ABC) system

Now, when we have learned about the process of an ABC system development, we can use an example to compare volume-based and activity-based costing and learn to apply ABC.