Updated July 15, 2023
Introduction to Activity Based Costing
Activity-based costing, also known as ABC, considers an alternative approach to Product costing. Activity Based Costing allocates the overheads to the cost pools before absorbing them into units using cost drivers.
A cost pool is an activity that consumes the resources which, identifies the overheads, and then allocates them. Each cost pool has a cost driver with it. The industry has developed and adopted it to overcome the limitations of the traditional costing method.
Explanation
Activity Based Costing introduced to solve the problems associated with the traditional costing method. It divides the overheads into different cost pools and then allocates them. It identifies the activities in the organization, such as the purchase of material is an activity of purchase requisition, and follow-up from the suppliers of the product delivery is also an activity. It helps to divide the true overheads into the proper place, thus making the costing system more accurate. It helps to formulate the appropriate marketing and corporate strategy. Cost allocation is done more accurately; therefore, each product’s cost is fairer.
Objectives of Activity Based Costing
The main objective of introducing this on Costing is that the traditional costing method had some limitations due to which the product cost was not calculated accurately. Thus it affects the cost per unit of the product. The overheads allocate arbitrarily in the traditional costing method; sometimes, the allocation depends on the production volume, which is not a correct cost method. Therefore, the Activity Based Costing method was introduced. In an organization, the Activity Based Costing method helps to control the cost because the cost is measured accurately due to the fairer distribution of the overheads.
How Does it Work?
It works as per the steps mentioned below.
- Step 1 – Find out the activity related to the production overhead.
- Step 2 – Identify the cost drivers for every activity.
- Step 3 – Calculate the cost driver rate of the activity.
- Step 4 – Absorption of activity into the product.
- Step 5 – Now calculate the production cost.
- Step 6 – Find out the profit and loss.
Example of Activity Based Costing
Otis worldwide corp is a company that produces 2 items, A and B.
- Total Quantity- A- 1000, Total Quantity – B- 2000
- Direct Material A-$5/unit. Direct Material B-$ 6/unit.
- No. of purchase requisition-A- 120, No. Of purchase requisition B- 180.
- Production Overhead-$10,000. It segregates into two departments equally, i.e., Inspecting and Production Set up.
- No. of batches received for inspection = 50.
- No. of batches received for production setup = 80.
Solution:
We require to find out the cost per unit as per the ABC method.
Cost Drivers Rate for A
Cost Drivers Overhead Rate calculates as:
| Inspection department overhead | 5000 |
| No. of batches to be inspected | 50 |
| Cost Driver Rate | 100 |
Cost Drivers Rate for B
Cost Driver Rate calculates as
Cost Driver Rate = Production Set up / No Batches Received for Production Setup.
| Production Set up. | 5000 |
| No. of batches received for production setup | 80 |
| Cost driver rate | 62.5 |
| Particulars | A | B |
| Direct Material | 5 | 6 |
| Overhead | ||
| Inspection | 12 | 9 |
| Production Set up. | *7.5 | 5.625 |
| Total cost per unit | **24.5 | 20.625 |
- *(Cost driver of Inspection*No. of purchase requisition) / Total quantity.
- ** (Cost driver of Production Setup*No. of purchase requisition) / Total quantity.
Uses of Activity Based Costing
- Activity Based Costing (ABC) achieves better allocation of overhead costs.
- It also controls the cost.
- The allocation of overheads follows the identification of cost drivers.
- The cost per unit calculation is done more accurately.
Application of Activity Based Costing
It is applied mostly in big companies with too much overheads and cannot be allocated in a single overhead activity. It is used mostly in complex situations where the cost allocation requires some expertise. Since cost drivers are required to be found out, it is mainly used in the service sector, where cost allocation becomes a challenge.
Advantages
Some of the advantages are given below:
- It is more accurate and reliable than traditional costing methods.
- In Activity Based Costing, the proper allocation of overheads is done, which helps to find the correct cost per unit of the product.
- It helps to subside the limitation of a traditional method.
- It helps in a capital investment decision.
- Market research becomes easy if we opt for Activity Based Costing.
- Activity Based Costing also helps in decision making by the management of the company.
- Measuring the cost drivers and allocating can help the management get fair and easy pricing.
Disadvantages
Some of the disadvantages are given below:
- It has been seen that Activity Based Costing can sometimes be irrelevant, especially in those cases where the overhead allocation is not done properly.
- Sometimes the cost allocation is done arbitrarily or by taking certain assumptions.
- Expert knowledge requires if the company follows the Activity Based Costing method since it can be difficult to identify the cost drivers followed by the allocation. Thus the cost per unit calculation can affect very badly.
- The Activity Based Costing is also somewhat expensive because hiring an expert to carry on the process can be a bit higher.
Conclusion
Activity Based Costing is a method companies use to arrive at an accurate cost or price of the product. It is a very effective tool and can help the organization reach a fair allocation of the overheads. Cost pool and cost drivers are taken care of in this method. This method can be very budget-friendly if used properly. It is better than the traditional method in many ways, and to overcome the limitation of the traditional method, this Activity Based Costing method is being introduced. Activity Based Costing helps in the decision making of the management.
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