What Is Activity-Based Costing (ABC)?
ABC is an accounting method for allocating costs to an organization or project more meaningfully than traditional methodologies. ABC estimates the total direct costs of manufacturing a product and then divides these amounts into direct costs and indirect costs.
The amount spent on particular goods or services indicates how much profit that product generates, even if the consumer receives a free product or service in the form of free advertising. ABC is a profit method because it recognizes profits from technological improvements and consumer purchases that produce excess costs previously borne by the manufacturer.
How Activity-Based Costing (ABC) Works?
Activity-based costing (ABC) is a process for better allocation of costs in a manufacturing business. The most common use of ABC is for product cost calculations in which the product costs are allocated to the production departments, administrative departments, and inventory accounts.
These accounts are subsequently used to produce reports that accurately reflect the varying levels of profitability from products at different stages in the company product cycle.
Focused on the costliness of activities, ABC looks at cost drivers to identify costs efficiently and accurately. This scheme helps managers solve profit-loss-related issues to implement a better pricing strategy.
The formula to calculate the ABC is
ABC = Cost pool total/Per unit cost driver
The cost driver rate is the basis for overhead allocation. It’s used to calculate the amount of indirect cost applied to a product or project.
Follow the below steps to calculate the ABC
- The first step is to identify all the steps involved in making your product.
- Allocate overhead costs into relevant cost pools and then calculate the total overhead for each.
- Assign each cost pool an activity cost driver, such as how many hours or units of a product were produced.
- For each cost pool, calculate the overhead rate by dividing the total overhead by the total cost drivers.
- To find the cost driver rate, divide the total overhead for each cost unit by the total units of that cost.
- The cost per unit is calculated by dividing the cost driver rate by the number of cost drivers.
Requirements for Activity-Based Costing (ABC)
The Activity-Based Costing (ABC) system of cost accounting is a process that ties costs to the activities generating the costs. An activity is an event, a unit of work, or a task with a specific goal, such as setting up machines for production. Activities consume overhead resources and generate costs.
The ABC system uses a cost driver, any event or transaction that affects your business expenses. Cost drivers are the items that determine the amount of an allocation base. Some examples of cost drivers are machine setups, repair requests, consumed power, purchase orders, quality inspections, and production orders.
There are two distinct types of activity measures: transaction drivers, which count how many times an activity occurs, and duration drivers, which measure how long it takes to complete.
ABC is a comprehensive cost management approach that uses five different types of activity to measure overhead costs. These are batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.
Benefits of the ABC system
The most significant benefit of activity-based costing is that it allows for making the best choices for the use of your limited budget.
You will avoid costly mistakes such as finding something cheaper than what you need or something that isn’t very good at what it is supposed to do.
2. Overhead Cost
Activity-based costing is a cost management method that uses an overhead cost estimate to determine whether an activity will be undertaken.
Each activity is assigned a weight ranging from 0 (no weight) to 1 (strict weight). If the activity is not required to accomplish the purpose of the cost structure, it is not worth pursuing.
3. Accurate product pricing
Pricing your products is an important part of any business and will determine how much you take in and how much you charge out. If you don’t consider marketing and other factors, you could have bad information leading to poor decisions being made. ABC, in a nutshell, is an activity-based costing approach to pricing.
It divides production into different activities, each with its own set of costs, returns, and risks. By grouping activities and pricing them based on their contribution to the whole, you can get an accurate idea of how much something costs.
Limitations of ABC system
- It is complex: activity-based costing doesn’t work very well for complex systems. For example, it’s challenging to put a price on the process of assembling a website or a mobile app or a new marketing campaign. So the price might also include inputs like building equipment or hiring staff, which gets a bigger price tag.
- Not 100% accurate
- Activity-based costing, or ABC, is a system of accounting that helps a firm assign overhead costs to the specific products, activities, or services they help create. By using ABC, managers can better allocate overhead, which helps them quickly identify the cheapest way to produce each product.
- The ABC method identifies and eliminates those products and services that are unprofitable. Also, the ABC method lowers the prices of overpriced products and services.
- Clearly identifies the most effective processes for producing or delivering each product and determines which products must be produced in-house vs. those purchased from outside vendors.
Questions to consider when implementing ABC
- Do we have the people, infrastructure, and systems in place to implement ABC?
- Are there any hidden costs of implementing ABC?
- Will your business be able to use or manage ABC?
- Will the costs of ABC-ing outweigh the benefits?
- Are there any activities or costs that get forgotten?
- Is there sufficient support from management and other key stakeholders to implement ABC
- What specific improvements will be made possible by this?
- Will the information we get from ABC help us make better decisions? Will this result in profit?
How Activity-Based Costing is Used?
ABC systems are used by businesses to determine overhead cost allocation more precisely. If you’re using an activity-based costing system, you’ll be gaining important information for most of the below issues.
1. Activity costs
ABC is an excellent feedback tool for measuring the ongoing cost of specific services as management focuses on cost reduction.
2. Customer profitability
Most of the costs for individual customers are product costs, but there’s also an overhead component, such as unusually high customer service levels and product return handling. ABC systems allow companies to break down overhead costs into easily analyzed categories, such as customer types.
This information can determine which customers are profitable and which ones are costing the company money.
3. Distribution cost
The cost of maintaining distribution channels is typical overhead, but the cost to use each channel differs due to their different abilities to sell your products.
Thus, you can alter how distribution channels are used based on their relative strengths and weaknesses.
4. Make or buy
ABC serves as a road map for which costs you can remove if you outsource production and which costs you should retain even if you do outsource.
An ABC system can determine the margins of various products, product lines, and entire subsidiaries. This can be used to determine where to position company resources to earn the largest margins.
6. Minimum price
Product pricing is based on what the market will bear. However, it’s important to know both the product cost and overhead costs to avoid selling a product that will lose the company money on every sale.
Marketing managers should know the cost of every product they sell to know whether the price they are charging is profitable. ABC is really good for figuring out which overhead costs should be included in that cost.
7. Production facility cost
The overhead costs at the plant-wide level are usually easy to identify, so you can easily identify them and compare them between different facilities.
ABC is useful when you decide that, while it’s not worth the time and effort to track the cost of every single activity, it’s worth the time and effort to track the cost of a smaller number of activities.