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Activity-Based Costing ABC: What is the Purpose?

Activity-Based Costing ABC: What is the Purpose?

For instance, a manager may aim at reducing cost of transporting the product from Rs. 5 per unit to Rs. 4.50 per unit. It refers to the drivers which directly charge for the resource used each time an activity is performed. Duration drivers determine the duration of time required to perform an activity. It simply means allocation and apportionment of various costs to a particular activity or group of activities.

  1. (e) Once processes are re-engineered, then the new costs must be tabulated.
  2. Hence the reported application for production tasks do not appear as a favorized scenario.
  3. Working on the principle that large cost savings are likely to be found in large cost elements, management’s attention will start to focus on how this cost could be reduced.
  4. Unit-based cost systems apportion fixed overhead to individual products and variable overheads are directly assigned to products using the base of number of units produced.
  5. The prerequisite for lesser cost in performing ABC is automating the data capture with an accounting extension that leads to the desired ABC model.

Thus, product will be charged for both machine related set up activity cost and inspection activity cost. These Include types of transactions which result in overhead costs e.g., purchase orders processed, customer orders processed, inspections performed and the set-ups undertaken, all count the number of times an activity is performed. It improves the traceability of the overhead costs which results in more accurate unit cost data for management. It increases the number of cost pools used to accumulate overhead costs. Thus, instead of accumulating overhead costs-in a single company- wise pool or departmental pools, the costs are accumulated by activities. In the stages above, we have identified the cost drivers and budgeted costs for each activity.

For example, apportioning utilities costs to particular activities is an educated guess, not a ‘to the penny’ calculation. Quite the journey from applying one accounting method to your product costs. Accurate pricing of goods and services is one of the most difficult things business owners need to tackle. One that’s going to attract customers because it realistically reflects value and isn’t overpriced. In contrast, Activity based costing (ABC) systems focus on activities required to produce each product or provide each service based on each product’s or service’s consumption of the activities. Activity-based costing incorporates in its costing system the basic and vital role of different activities.

The 4 types of activity-based costing activities

ABC has also enabled enterprises to model the impact of cost reduction and subsequently confirm the savings achieved. With ABC, any enterprise will have a built-in competitive cost advantage and can continuously add value to both its stakeholders and customers. Identification of non-value adding activities helps the management to control cost.

The overarching benefit to this costing method is to get a clearer and more detailed financial picture of your production costs. When you dig into it, you can use this to improve your business in several ways. Service businesses can also use activity-based costing to determine whether the services offered are accurately priced. This can be a simple process for small manufacturing businesses, or may require a great deal of time and research for larger manufacturers using more completed processes.

Difference Between Traditional Costing and Activity-Based Costing

There is a very high probability of an ABC system providing a different picture of product costs than what is provided by the traditional system. However, since both methods make assumptions about the behaviour and cause of costs, it cannot be said with certainty that ABC shall always produce more precise results than traditional costing. That means, overhead expenses are initially identified with the cost centres (i.e., departments, divisions, branches, etc.) abcosting and then, they are identified with, and charged to, the products. It may be noted here that the prime costs are identified with, and charged directly to, the products. Activity Based Management (ABM) differs from Activity Based Costing (ABC). Activity Based Costing (ABC) establishes relationship between overheads costs and activities in order to ensure that the overheads costs are more precisely allocated to products, services or customers segments.

What is a service level in ABC?

But in case of ABC, set up and adjustment time is determined for each department and its cost is directly charged to each department. Therefore ABC tries to ascertain the factors which are responsible for each major activity, costs of these activities and relationship between activities and products. Activities can be defined as a named pro­cess, function, or task that occurs over time and has recognized results. Activities use up assigned resources to produce products and services.

This approach of the conventional method is over-simplistic and does not seem to produce individual product costs with greater accuracy and precision. However, it’s quick, and the cost allocation process can be completed in less time. Marginal costing is a method to calculate the total cost of production. It is concerned with the variable cost component, i.e., additional costs incurred for producing an extra product unit. Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988.

Activity Based Costing – Cost Pool and Cost Drivers (With Examples)

In the table below in Example 2 the total overheads have been split into cost pools and cost driver data for the Ordinary and Deluxe products has been collated. For instance, the utility cost of running production machines would be included in the running machines cost pool. In order to use activity-based costing correctly, you will need to calculate the cost for each activity identified in Step 1 in order to determine costs. Activity-based costing is a cost accounting method designed to help businesses accurately price their products. Used in large-scale manufacturing companies, activity-based costing can also be a helpful tool for smaller manufacturers. Even in ABC, some overhead costs are difficult to assign to products and customers, such as the chief executive’s salary.

The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level cost. This means that $200,000 will first be allocated to batches of products to be manufactured (referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch (referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units).

Activity based Costing (ABC) is a systematic, cause & effect method of assigning the cost of activities to products, services, customers or any cost object. By using activity-based costing, the business understands that Product A has a higher overhead cost per unit than Product B. Identifying and assigning costs to each activity lets you better understand the cost of your products or services and make more informed decisions about pricing specific products and resource allocation.

So, the pre-determined absorption rate can be calculated with the following formula. The use of the ABC system requires monitoring small details of activities and costs with more accuracy. Although, the use of the ABC system requires the use of more administrative resources. However, the results produced for the product costing and profitability are more accurate and precise.

It means, under ABC, the other two activities-batch level and product level are assumed to influence fixed overhead costs and batch and product level, thus are accepted as non-unit based cost drivers. Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product. Direct labour and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process.

Under traditional absorption costing, a firm aggregates indirect costs and apportions them to all products at an average single overhead rate. These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity. In traditional costing system, overhead costs are assumed to be influenced by only units produced. It means, in traditional costing system, cost of batch level, product level and facility level activities is fixed costs, i.e., costs of these do not change as production volume changes. Unit-based cost systems apportion fixed overhead to individual products and variable overheads are directly assigned to products using the base of number of units produced.

Traditionally, cost accountants had arbitrarily added a broad percentage of analysis into the indirect cost. In addition, activities include actions that are performed both by people and machine. (iv) Better Reporting – ABC system provides better reporting of cost of activities and their performance which will help in taking suitable decision and in improving efficiency. Where selling prices are fixed on the basis of cost plus formula, ABC provides more reliable data for fixing selling prices. This is a continuous improvement process in terms of analysing the cost, to reduce or eliminate the non-value-added activities and to achieve an overall efficiency.