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4: Activity-Based Costing
4.7: Activity-based costing for a service business to estimate factory overhead

4.7: Activity-based costing for a service business to estimate factory overhead

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Service businesses may also use activity-based costing to allocate general overhead costs to clients, patients, and guests, also by estimating costs of activities based on their use of resources, and assigning costs to customers based on their use of activities.

A hospital, for example, might identify the following activities whose general costs must be shared among patients. Each activity rate is estimated based on the activity’s budgeted overhead cost for the year divided by the number of occurrences expected during the year. For each patient stay, the number of times each activity occurs is multiplied by the overhead rate for that activity. The sum of all the activity costs is the amount of overhead applied to the cost of servicing the patient.

ABC costing for a patient’s six-day stay in a hospital is summarized in the following table.

Activity	Activity Rate (estimated)	Patient usage	Patient Costs
Admissions	$70 per admission	1 admission	$70 x 1 = $70
Operating room use	$900 per hour	4 hours	$900 x 4 = 3,600
Dispensing medications	$25 per administration	3 times per day / 6 days	$25 x 3 x 6 = 450
Radiology testing	$290 per image	2 images	$290 x 2 = 580
Diagnostic lab	$150 test	6 tests	$150 x 6 = 900 = 900
Medical assistance	$20 per visit	6 visits per day / 6 days	$20 x 6 x 6 = 720
Cleaning and laundry	$80 per day	6 days	$80 x 6 = 480
Discharge	$100 per discharge	1 discharge	$100 x 1 = 100
			TOTAL = $6,900

A total of $6,900 of overhead costs is associated with this patient’s hospital stay.

ABC increases the accuracy of allocating overhead by budgeting multiple targeted activities that can be estimated more precisely than relying on one general overhead rate that applies to all overhead in a business This more granular approach also gives companies better insight into ways to control the cost of a product, such as reducing the time it takes to perform an activity or decreasing the number of times an activity occurs.

ABC helps managers, who already view costs by activity, and accountants communicate more effectively. “An activity-based system aligns organizational information with the business mission and operations rather than financial transactions. It tears down the barriers that segregate financial information from other information.” ¹