What is Activity Based Costing and How Does it work?

Activity-Based Costing (ABC)


What is Activity-Based Costing (ABC)?

Activity-based costing (ABC) is defined as a technique for allocating costs to acquisitions, tasks, service projects, and products, based on:

  1. Resources used up by such activities

  2. The events that go into them

ABC is very different from the traditional costing, better referred to as cost accounting, which occasionally allocates costs using a bit arbitrary apportionment percentages for overhead – also, referred to as indirect costs. As an outcome, traditional cost accounting and activity-based costing can forecast the price of goods traded and gross margin in a very different way for individual articles. Inconsistent and ambiguous cost estimations can be problematic for a company’s management as the management is keen on knowing the exact profit on product, along with the products which are lossmaking. ABC is an accounting system that classifies and allocates costs to overhead undertakings and then allocates those costs to products. This system identifies the association between manufactured products, overhead activities, and costs, and through this association, it allocates indirect costs to goods less arbitrarily than cost accounting. However, it might be tough to allocate certain costs such as office staff and management salaries through this method. Because of this challenge, the ABC system has found its position in the manufacturing sector.

ABC is usually adopted in the manufacturing business as it augments the consistency of cost data, therefore generating closely true costs and improved categorisation of costs experienced by an organisation during its fabrication process. This costing system is adopted in customer profitability analysis, product line profitability analysis, product costing, service pricing, and target costing. It is also immensely popular since organisations can cultivate a much improved corporate strategy and focus if prices are better computed.

Activity-Based Costing (ABC)

According to recent survey (Nov-18), many medium and big Irish firms are not adopting the more advanced costing techniques, to be exact, activity-based costing (ABC). Findings indicate that the rate of adoption of ABC is 18.7%, which is lower than preceding studies for Irish firms. The prime reason for not adopting the ABC revolves around established existing costing methods, which most Irish firms are satisfied with

Definition of Activities in ABC system

The ABC system is built on events, which is any occurrence, portion of work, or job with a precise goal, such as establishing machines for fabrication, distributing finished goods, designing products, or operating machines. Activities include overhead resources and are measured cost objects. According to the ABC structure, an activity can also be measured as any contract or incident that is an activity (cost) driver – an activity driver is used to denote an allocation base. Examples of activity drivers include power consumed, production orders, maintenance requests, machine setups, or quality inspections. There are two classes of activity measures: transaction drivers, which includes the number of times an activity has occurred, and duration drivers, which measure the time-period takes to complete an activity.

On the other hand, the traditional cost account system relies on volume count such as direct labor hours or machine hours to apportion indirect or overhead costs to goods. The ABC system categorises the activities into five all-encompassing levels of activity that are not linked to the number of units produced. Levels include:

  1. Batch-level activity

  2. Customer-level activity

  3. Product-level activity

  4. Organisation-sustaining activity

  5. Unit-level activity

Activity-based costing has expanded its footprint in recent decades because:

  1. Manufacturing overhead charges have become greater than before

  2. Manufacturing overhead charges no longer associate with the direct labor hours or productive machine hours

  3. The diversity of customer demands and products have expanded

  4. Certain products are manufactured in large lots, while others are manufactured in small lots

How ABC System Improves Costing Process?

Activity-based costing augments the costing process in three ways. Firstly, it increases the number of cost groups that can be considered to draw together overhead costs. As an alternative of amassing all costs in one organisation-wide group, it groups costs by activities. It also generates new bases for allocating overhead costs to products such that costs are assigned based on the events that create costs instead of on capacity measures, such as direct labor costs or machine hours. Lastly, ABC modifies the nature of numerous indirect costs, making costs formerly considered indirect – such as inspection, Depreciation, or power-traceable to some activities. On the other hand, ABC allocates overhead costs from high-volume goods to low-volume goods, increasing the unit cost of low-volume goods.

Read Also: Reducing Balance Method of Depreciation

Activity-based Costing Process Flow

Activity-based costing can be explained through various steps such as:

  1. Identifying Costs: The initial step in ABC is to categorise those costs that need to be allocated – this is the most important step in the whole process. For instance, if a business aims to define the entire cost of a distribution channel, it should take in account warehousing and advertising costs, and cost pertaining to research and other products

  2. Create Primary Cost Group: It is advisable to have segregate cost for each product line. Also, if production lots are of varying length, it is advisable to consider allocating cost for each batch level

  3. Create a Secondary Cost group: Identify Secondary Cost incurred to offer services to other Business Functions- secondary cost groups characteristically comprises of administrative salaries, computer services etc. Later, these are allocated to other cost pools that are in a straight line with products and services

  4. Evaluate Activity or Cost Drivers: A business can use a data management system to gather information about the cost drivers that are used to apportion the costs in primary and secondary

  5. Cost Objects: To distribute the costs, divide the entire cost in each cost group by the entire amount of activity in the activity or cost driver

  6. Formulate Reports: Translate the outcomes of the ABC system into information for management consumption

Uses of Activity Based Costing

  1. ABC provides a more precise cost per unit. As a result, decision making, performance management, pricing, and sales strategy should improve

  2. ABC offers much better understanding of what pushes overhead costs

  3. ABC identifies that overhead costs are not all associated to sales volume and goods produced

  4. In numerous companies, overhead costs are a noteworthy percentage of total costs. Overhead costs can be measured by handling cost drivers

  5. ABC system can be used for all overhead costs, not just manufacturing overheadsach cost group by the entire amount of activity in the activity or cost driver

  6. ABC can be applied to grow genuine costs in a multifaceted business environment

  7. ABC can be used easily in service costing

Problems with Activity-based Costing

  1. ABC will not be of much use if the overhead charges are volume driven or if the overhead is a minor percentage of the total cost

  2. It is difficult to assign all overhead charges to explicit activities

  3. The choice of both cost drivers and activities might be unsuitable

  4. It can be difficult to explain the stakeholders about ABC computation process

  5. The advantage achieved from ABC might not explain the costs

  6. Other structures may need to be altered – for instance, how variance is computed

Computing cost per unit using Activity-Based Costing

  1. Group production overheads into activities. For each cost or activity group, there must be a cost driver.

  2. Identify cost drivers for each activity

  3. Compute the overhead absorption rate (OAR) for each cost or activity

  4. Absorb the activity costs into products

  5. Compute the complete production cost for each unit, along with profit or loss.

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