Activity-Based Costing ABC: Method and Advantages Defined with Example

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Manufacturing overhead refers to the costs of manufacturing that are considered indirect costs. Using this method helps provide a more accurate representation of all the costs of making a product. Activity-based costing is a costing method that assigns manufacturing overhead costs to products based on cost pools and cost driver activity. These cost pools are then allocated to products based on the cost driver for that specific cost pool. Traditional costing is a costing method that allocated all manufacturing overhead to products based on a single cost driver.

What is the formula for activity-based costing?

ABC is a methodology that is used to determine the total cost of manufacturing a product. It is calculated by considering two factors total cost pool and the cost driver. I.e. Cost pool total / Cost driver = Activity-based costing.

Here we can mention not just more transparent cost data for each department, but also a review of internal controls and greater visibility for every process. This optimization of cost control brings countless benefits to all of the company’s departments as we’ll show below. The trigger missing for the popularization of this methodology was the rise of micro-computing at the end of the 1980s and the development of software GUIs through operational systems such as Windows , OS/2 and Mac . With these events, applications that previously could only be run on large computers and mainframes could now be run by any organization and were accessible to a wide variety of users and departments. These technological advances made it possible for the system to be taken off the drawing board and put into practice, mainly in the implementation of costing models for more complex organizations which require greater detail.

Asia Pacific Management Review

The activity based costing methods applied for absorbing overheads lay emphasis on the calculation and application of overhead recovery rates which are acceptable for the valuation of stocks for the purposes of routine financial reporting. The management does not find these traditional methods helpful in making complicated decisions related to product strategies. Identification of cost during activities and their causes not only help in computation of more accurate cost of a product or a job but also eliminate non-value added activities. The elimination of non-value added activities would drive down the cost of the product. In order to overcome the problems faced in traditional approach of overhead distribution, a new and more scientific approach was developed by Cooper and Kalpan known as Activity based costing.

A cost driver is a factor the change of which results in a consequential change in the total cost of a related object. If its level changes, it brings a corresponding change in the level of total cost of the related cost object. As manufacturing overhead costs have increased significantly and they no longer correlate with the productive machine hours or direct labour hours. Activity-based costing is different from standard-based costing and other traditional methods. These other methods do not account for indirect costs and focus only on specific costs that go into the product, such as labor or materials. Activity-based costing is different from traditional methods or standard-based costing. These methods rely on factors concerning direct costs, such as resources and labor.

How Activity-Based Costing (ABC) Works

In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. 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 , and then be assigned to the units of product in each batch . 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). If Batch Y is 50,000 units, the cost per unit for setup will be $0.01 ($500 divided by 50,000 units). For simplicity, let’s assume that the remaining $1,800,000 of manufacturing overhead is caused by the production activities that correlate with the company’s 100,000 machine hours.

What is activity-based costing in simple words?

Activity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with a specific goal.

Once your Resources and Activities have been defined, determine the cost drivers you wish to use and the criteria for each one. Eliminating these practical implementation problems, the MyABCM product suite is the global leader in cost management solutions. With its multidimensional analyses, organizations can use it to model, analyze, and create simulations with great flexibility and security providing full integration with the organization’s corporate systems. Many companies already possess a costing mechanism that uses spreadsheets. Others try to customize their ERP or even believe that BI can solve cost management. The implementation of an ABC Costing system may seem complicated, and it will vary somewhat depending on the size and complexity of the activities, products and services of each company. This methodology means that these values only reflect an estimated average.

Activity Based Costing with Two Activities

The disadvantages of the ABC method include it being expensive to implement, as well as maintenance, being a time-consuming process, being used only for internal reporting, and having the possibility of some excluded costs. The ABC method reveals realistic costs of production for each model. 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.

It should be noted that costs do not need cost drivers as they can be identified directly to a product. Therefore cost drivers signify factors, forces or events that determine the costs of activities. In ABC, variable overhead is appropriately traced to individual products.


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