is a costing technique that assigns overheads to the products or services rendered.
Activity-Based Costing Details
Activity-Based Costing, (ABC), follows a logical approach in allocating manufacturing overheads. It is a more accurate costing technique than traditional costing. Conventional costing classifies cost as either fixed or variable. It assumes that variable cost varies with the number of units produced, while the fixed cost does not change with production. Traditional costing is a simplification of how costs behave.
In reality, variable costs per unit will increase when production levels increase, where other additional expenses such as overtime costs arise. The assumption that fixed costs are constant is not correct. This will hold only over a given range of activity levels, often stepping up as additional manufacturing resources are employed to allow more production volumes.
Also, while the conventional approach assumes that costs arise due to the passage of time, they can be absorbed based on labor or the machine hours spent in each unit of production. It is not a more accurate approach to determining the unit cost. Modern manufacturing requires diverse and flexible manufacturing systems that can estimate the costs more accurately.
ABC is a more precise estimate of what each unit will cost to produce. ABC examines all the activities necessary in the production of one unit of output. The basis of activity costing is the unit cost attached to each unit of output.
Steps in Activity-Based Costing
- First, identify the significant activities that give rise to overheads, such as ordering, dispatching, etc. Cost-pool is another term for these costs.
- Determine what causes each activity from the cost pool identified to determine the cost driver - what causes/drives that cost, e.g. The number of dispatch hours.
- Then compute the absorption rate for each unit of the cost driver by dividing the cost pool by the total number of a cost driver.
- Finally, calculate costs to the products produced and the cost per unit based on the rate each product uses the cost driver.
Example of Activity-Based Costing (ABC)
Below is an example of company X that produces two products Alpha and Beta. The budgeted production units are Alpha 20,000 and Beta 1,000.
Cost Pool $
Batch setup 60,000
Store handling 42,000
Cost Driver Alpha Beta
Batch Size 1000 100
Number of components per unit 10 20
The first step of the ABC costing process (identification of the cost pool) is complete from the data above. The second step is to establish the cost driver of each cost pool.
The Batch set up will be determined by the batch size:
Alpha 20,000/1000 = 20
Beta 1000/100 = 10
The total setups =30
The store handling cost will be driven by the number of components required:
Alpha (20,000 units 10) = 200,000
Beta (1000 Units x10) = 10,000
Total Components = 210,000
The third step is to establish the cost per unit of each cost driver:
The batch set-up is $ 60,000/30 = $ 2,000 per set up
Store handling is $ 42,000/210,000 = $ 0.2/ labor hour
The fourth step requires absorption of cost per unit into each product based on the cost driver used:
Batch set up
Alpha $ 2,000/1000 units = $ 2/ unit
Beta $ 2000/100 units = $ 20/ unit
Alpha $ 0.2 x 10 units = $ 2/ unit
Beta $ 0.2 x 20 units = $ 4/ unit
Based on the absorption above, the variable overhead cost per unit is:
Batch Set up $2 $20
Material Handling $2 $4
Total production overheads $4 $24
Significance of Activity-Based Costing
While ABC can be a complicated process in a manufacturing setup with many cost drivers, firms should be ready to spend time and effort investigating what causes the cost to rise and then to utilize this information for costing purposes. Understanding cost drivers is critical for effective performance management.
Activity-Based Costing can be useful in providing an organization with a better view of its cost structure. It will enable them to form an appropriate pricing strategy. It is also helpful for companies in determining long-term strategic goals and competitive cost advantage.
However, it also has its challenges. ABC uses several cost pools and drivers. Selection and measurement of the drivers can be difficult, making it more complicated than the conventional costing technique. It can be quite costly to implement it in an organization.