What is Activity Based Costing?

Activity based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. Therefore this model assigns more indirect costs (overhead) into direct costs compared to conventional costing.

Companies have expressed frustration with arbitrary allocations associated with traditional costing methods. This has led to increased utilization of a uniquely different approach called activity-based costing (ABC).

It was within this context that Activity Based Costing or ABC first appeared. The ABC system is based on the analysis of specific costs related to every activity performed by a company in the manufacturing of its products or services.

Based on these activities, resources are allocated to various products, services, markets, etc., generating a clear vision of the company’s costs. In this manner, the company has a more precise view of the impact of each activity on the operational costs of the business, facilitating more adept management of its profitability.

Activity Based Costing

Activity-based costing

What we want to do is to get a more accurate estimate of what each unit costs to produce, and to do this we have to examine what activities are necessary to produce each unit because activities usually have a cost attached. This is the basis of activity-based costing (ABC).

The old approach of simply pretending that fixed costs are incurred because of the passage of time and that they can therefore be accounted for on the basis of labor (or machine) time spent on each unit, is no longer good enough. Diverse, flexible manufacturing demands a more accurate approach to costing.

The ABC process is as follows:

  • Split fixed overheads into activities. These are called cost pools.
  • For each cost, the pool identifies what causes that cost. In ABC terminology, this is the ‘cost driver’, but it might be better to think of it as the ‘cost causer’.
  • Calculate a cost per unit of cost driver (Cost pool/total number of cost drivers).
  • Allocate costs to the product based on how much the product uses the cost driver.

Let’s continue with our example from earlier; the total fixed overheads were $224,000. 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.

Benefits Of ABC

Activity-based costing attempts to overcome the perceived deficiencies in traditional costing methods by more closely aligning activities with products. This requires abandoning the traditional division between product and period costs, instead of seeking to find a more direct linkage between activities, costs, and products.

This means that products will be charged with the costs of manufacturing and nonmanufacturing activities. It also means that some manufacturing costs will not be attached to products. This is quite a departure from traditional thought.

With ABC a product is only charged with the cost of capacity utilized. Idle capacity is isolated and not charged to a product or service. Under traditional approaches, some idle capacity may be incorporated into the overhead allocation rates, thereby potentially distorting the cost of specific output. This may limit the ability of managers to truly understand and identify the best business decisions about product pricing and targeted production levels.

The formula of Activity Based Costing

The formula for activity-based costing is the cost pool total divided by the cost driver, which yields the cost driver rate. The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity. 

The ABC calculation is as follows:  

  • Identify all the activities required to create the product. 
  • Divide the activities into cost pools, which include all the individual costs related to an activity—such as manufacturing. Calculate the total overhead of each cost pool.
  • Assign each cost pool activity cost drivers, such as hours or units. 
  • Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers. 
  • Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate. 
  • Multiply the cost driver rate by the number of cost drivers. 

As an activity-based costing example, consider Company ABC which has a $50,000 per year electricity bill. The number of labor hours has a direct impact on the electric bill. For the year, there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ, the company uses electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.

The formula of Activity Based Costing

Differences between Activity Based Costing and Traditional Costing Systems

Traditional costing systems arose to meet tax requirements and stock valuations, but these systems have various flaws, especially when used as management tools.

This happens because these traditional costing methodologies are focused on the various products that companies offer. Costs are assigned equally among these products because it’s assumed that each item/SKU consumes the organization’s diverse resources in proportion to the volume of the products produced.

In this way, various “volume” drivers such as direct labor hours, machine hours, and raw material allocation of costs are used as criteria to assign overhead costs.

This methodology means that these values only reflect an estimated average. Even though a complex study is used to arrive at this calculation, this is a scenario that by definition will never correspond exactly to the specific characteristics of each company and its individual processes.

These volume-based drivers also fail due to the diversity in the form, size, and complexity of these products. There’s also no direct relationship between the production volume and the effort or costs consumed by the organization.

As a result, many managers of companies that offer a variety of products and services are making very mistaken decisions in terms of prices, their mixes of products and services, and their processes.

Advantages of Activity-Based Costing

The fundamental advantage of using an ABC system is to more precisely determine how overhead is used. Once you have an ABC system, you can obtain better information about the issues noted below.

Learn About Activity Costs

ABC is designed to track the cost of activities, so you can use it to see if activity costs are in line with industry standards. If not, ABC is an excellent feedback tool for measuring the ongoing cost of specific services as management focuses on cost reduction.

Identify Profitable Customers

Though most of the costs incurred for individual customers are simply product costs, there is also an overhead component, such as unusually high customer service levels, product return handling, and cooperative marketing agreements. An ABC system can sort through these additional overhead costs and help you determine which customers are actually earning you a reasonable profit. This analysis may result in some unprofitable customers being turned away, or more emphasis being placed on those customers who are earning the company its largest profits.

Calculate Cost of Distribution Channels

The typical company uses a variety of distribution channels to sell its products, such as retail, the Internet, distributors, and mail-order catalogs. Most of the structural cost of maintaining a distribution channel is overhead, so if you can make a reasonable determination of which distribution channels are using overhead, you can make decisions to alter how distribution channels are used, or even drop unprofitable channels.

Decide When to Outsource

ABC provides a comprehensive view of every cost associated with the in-house manufacture of a product, so that you can see precisely which costs will be eliminated if an item is outsourced, versus which costs will remain.

Calculate Product Margins

With proper overhead allocation from an ABC system, you can determine the margins of various products, product lines, and entire subsidiaries. This can be quite useful for determining where to position company resources to earn the largest margins.

Set Minimum Price Points

Product pricing is really based on the price that the market will bear, but the marketing manager should know what the cost of the product is, in order to avoid selling a product that will lose company money on every sale. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold.

Disadvantages of Activity Based Costing

Many companies initiate ABC projects with the best of intentions, only to see a very high proportion of the projects either fail or eventually lapse into disuse. There are several reasons for these issues, which are noted below.

Too Many Cost Pools

The advantage of an ABC system is the high quality of information that it produces, but this comes at the cost of using a large number of cost pools – and the more cost pools there are, the greater the cost of managing the system. To reduce this cost, run an ongoing analysis of the cost to maintain each cost pool, in comparison to the utility of the resulting information. Doing so should keep the number of cost pools down to manageable proportions.

Difficult to Install

ABC systems are notoriously difficult to install, with multi-year installations being the norm when a company attempts to install them across all product lines and facilities. For such comprehensive installations, it is difficult to maintain a high level of management and budgetary support as the months roll by without installation being completed. Success rates are much higher for smaller, more targeted ABC installations.

Requires Data from Many Sources

An ABC system may require data input from multiple departments, and each of those departments may have greater priorities than the ABC system. Thus, the larger the number of departments involved in the system, the greater the risk that data inputs will fail over time. This problem can be avoided by designing the system to only need information from the most supportive managers.

Information Only Collected Once

Many ABC projects are authorized on a project basis, so that information is only collected once; the information is useful for a company’s current operational situation, and it gradually declines in usefulness as the operational structure changes over time. Management may not authorize funding for additional ABC projects later on, so ABC tends to be “done” once and then discarded.

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