Activity-based costing ABC Resources

We will assume that a company has annual manufacturing overhead costs of $2,000,000—of which $200,000 is directly involved in setting up the production machines. Let’s also assume that the batch sizes vary considerably, but the setup efforts for each machine are similar. Activity-based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities. The number of activities a company has may be small, say five or six, or number in the hundreds.

What is the purpose of activity-based costing?

The objective of ABC is to assign specific resources and break overhead costs between production-related activities. This type of costing relies on different activities, such as product design or unit of work.

Under ABC, the company will calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. In our example, Product 124 will be assigned some of the company’s costs of special engineering, special testing, and machine setup.

What are the different types of cost drivers under ABC?

It is very important to find out the things that determine the cost of an activity. Under the traditional absorption costing method, Product ‘R’ is more expensive while under Activity-Based Costing method, product ‘P’ is more expensive. A major advantage of using Activity based costing (ABC) is that it avoids or minimizes distortions in product costing that result from arbitrary allocations of indirect costs. Typical attributes include the number of direct labor hours required to manufacture a unit, purchase cost of merchandise resold or the number of days occupied. Traditional cost accounting techniques allocate costs to products based on attributes of a single unit. Activity based Costing (ABC) is a systematic, cause & effect method of assigning the cost of activities to products, services, customers or any cost object.

  • However, ABC also poses some challenges that need to be considered before implementing it.
  • These costs are termed ‘business sustaining’ and are not assigned to products and customers because there is no meaningful method.
  • This can help the firm to price its services more accurately, improve its profitability and identify areas for improvement.
  • The ABC provides information about the cost incurred on each production activity; with that help, the management can decide which activity is profitable to perform domestically and which is required to be outsourced.

Therefore, activity-based costing considers all the potential activities instead of relying on just one variable (for example, labor hours or machine hours). ABC produces more accurate costing of products by essentially converting broad indirect costs into direct costs of production. It determines the costs of the various sources of indirect costs and allocates these expenses to the specific activities that use them. Overhead costs are allocated to products by multiplying the predetermined overhead rate for each activity (calculated in step 4) by the level of cost driver activity used by the product. ABC focuses attention on cost drivers, the activities that cause costs to increase. Traditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received.

Step 2 of 3

This is done by dividing estimated overhead costs for each activity by the estimated cost driver activity. If actual overhead costs are lower than applied overhead, the resulting overapplied overhead is closed with a debit to manufacturing overhead and a credit to cost of goods sold. If actual overhead costs are higher than applied overhead, the resulting underapplied overhead is closed with a debit to cost of goods sold and a credit to manufacturing overhead. This information includes an estimate of the level of activity for each cost driver, which is needed to calculate a predetermined rate for each activity.

Activity-Based Costing

ABC can also affect the culture, communication, and coordination of the organization, as it can create conflicts or resistance among different departments or units. Therefore, P&L managers need to ensure that ABC is aligned with the organizational structure, culture, and strategy, and that it is supported by the top management and the stakeholders. The ABC analysis shows that the total cost of production for Swifty Feet is actually $53.91 per pair, not $55.00 as originally calculated. These differences in costs of production have implications for profit planning, production scheduling and spending for marketing campaigns. Overhead is allocated, or applied, to products (auto loans and home equity loans in this example) based on the use of each activity’s cost driver.

Difference between the Traditional Absorption Costing Method and the Activity-Based Costing Method

Activity costs tend to behave in a similar manner to each other i.e., they have the same cost driver or the factor causing a change in the cost of an activity. The basic feature of functional departments is that they tend to include a series of different activities causing different costs that behave in different ways. Thus, the activity based system system uses activities instead of functional departments (Cost Centers) for absorbing overheads. Activity based costing is also known as ABC costing, the ABC method, and the ABC costing method. When a company asks its employees to report on the time spent on various activities, they have a strong tendency to make sure that the reported amounts equal 100% of their time. However, there is a large amount of slack time in anyone’s work day that may involve breaks, administrative meetings, playing games on the Internet, and so forth.

For example, a lawyer may spend more time on research or negotiation for some cases than others, or a teacher may use different teaching methods or materials for different students. Therefore, it can be hard to define and quantify the activities and their cost drivers in a consistent and reliable way. Another challenge is the high cost and time required to implement and maintain ABC. ABC requires a lot of data collection, analysis and updating to reflect the changes in the activities and their costs. It also requires a lot of training and communication to ensure that the staff understand and accept the ABC system and use it effectively.

This can, without proper understanding, give some people an inaccurate understanding which can then lead to poor decision making. For example, allocating PPE to individual products, may lead to discontinuation of products that seem unprofitable after the allocation, even if in fact their discontinuation will negatively affect the bottom line. Applicability of ABC is bound to cost of required data capture.[1] That drives the prevalence to slow processes in services and administrations, where staff time consumed per task defines a dominant portion of cost. Hence the reported application for production tasks do not appear as a favorized scenario. Fill in the following table to identify if the cost item can be included in the cost of products for external reporting purposes and/or internal reporting purposes. Under the activity-based approach, the unit cost card gives different unit product costs for each product.

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