Activity-Based Costing (ABC) is a methodology that assigns overhead and indirect costs to associated products and services. Unlike traditional costing methods, ABC recognizes the intricate relationship between costs, overhead activities, and manufactured products, leading to more accurate cost allocation. This allows companies to make well-informed pricing decisions.
Key Takeaways
- Activity-Based Costing (ABC) helps allocate overhead and indirect costs, such as salaries and utilities, effectively to products and services.
- This accounting method revolves around activities, defined as any unit of work or task that has a specific goal.
- Activities are typically driven by cost drivers like purchase orders or machine setups.
- The cost driver rate, derived by dividing the cost pool total by the cost driver, aids in calculating the pertinent overhead and indirect costs for each activity.
ABC enhances cost comprehension, aiding companies in developing appropriate pricing strategies.
How Activity-Based Costing (ABC) Works
Primarily utilized in the manufacturing sector, ABC improves the reliability of cost data, providing nearly true costs and better distinguishing the costs incurred during production. This system assists in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing.
Here’s the step-by-step process of ABC:
- Identify Activities: Find all the activities necessary to produce the product.
- Create Cost Pools: Group all the individual costs related to an activity, such as manufacturing, into cost pools and calculate the total overhead of each pool.
- Assign Cost Drivers: Link each cost pool to activity cost drivers like hours or units.
- Calculate Cost Driver Rate: Divide the total overhead by the total cost drivers in each pool.
- Allocate Costs: Multiply the cost driver rate by the number of cost drivers to assign overhead effectively.
Activity-Based Costing Example
Imagine a company with a $50,000 annual electricity bill and 2,500 labor hours. The labor hours, in this case, are the cost driver. By dividing the $50,000 by 2,500 hours, we get a cost driver rate of $20. If Product XYZ consumes electricity for 10 hours, the overhead cost for this product is $200 ($20 times 10 hours).
Requirements for Activity-Based Costing (ABC)
ABC views activities as any event or task aimed at achieving a goal, impacting overhead resources and considered cost objects. A cost driver, or activity driver, signifies any transaction or event that demands resource allocation.
Categories of Activity Measures
- Transaction Drivers: Measure the frequency of activities.
- Duration Drivers: Track how long each activity takes.
Different Levels of Activity
Unlike traditional methods dependent on volume count, ABC classifies activities across five broad levels:
- Batch-Level: Activities that occur per batch of items produced.
- Unit-Level: Activities that directly impact each unit of production.
- Customer-Level: Activities performed to serve customers.
- Organization-Sustaining: Fundamental activities maintaining the organization’s operating systems.
- Product-Level: Activities linked to specific products.
Benefits of Activity-Based Costing (ABC)
ABC enhances costing accuracy in several key ways:
- Expand Cost Pools: ABC uses multiple cost pools instead of one company-wide pool, making overhead analysis more refined.
- Intelligent Cost Allocation: ABC assigns overhead based on activities that generate costs instead of mere volume measures like machine hours or direct labor.
- Indirect Cost Tracing: Previously indirect costs like depreciation, utilities, or salaries become traceable to specific activities.
ABC shifts overhead costs from high-volume to low-volume products, which could increase unit costs for produced items in lower volumes. This granular approach ensures a clearer, more manageable view of costing, benefiting pricing strategies and resource allocation.
Related Terms: overhead, cost accounting, cost driver, unit cost, batch-level activity, depreciation.
References
- Chartered Global Management Accountant. “Activity-Based Costing (ABC)”.
