Activity-Based Costing (ABC) is a costing technique used to assign costs to products, services, or activities based on the resources they consume. It provides a more accurate way of understanding the true cost of producing a product or delivering a service by focusing on the activities and processes involved. ABC is particularly useful in complex business environments where traditional costing methods may not accurately reflect the actual cost drivers. Activity-Based Costing
ABC is based on the principle that ‘products consume activities.’ Traditional cost systems allocate costs based on direct labour, material costs, revenue, or other simplistic methods. As a result, traditional systems tend to over-cost high-volume products, services, and customers, and under-cost low volume.
Activities can be defined as a named process, function, or task that occurs over time and has recognized results. Activities use assigned resources to produce products and services.
As quoted by Horngren, Foster, and Datar, “ABC is not an alternative costing system to job costing or process costing. Rather, ABC is an approach to developing the cost numbers used in job costing or process costing systems. The distinctive feature of ABC is its focus on activities as the fundamental cost objects. In contrast, more additional approaches to developing the cost numbers used in job or process costing systems rely on general-purpose accounting systems not tailored to the activities found in individual organizations. The ABC approach is more expensive than traditional approaches. ABC has the potential, however, to provide managers which information they find more useful for costing purposes.”
Let us deep dive into the Activity-Based Costing technique:
1.Cost Attribution to Activities:
Identifying Activities: ABC starts by identifying all the activities within an organization. These could be related to production, administrative tasks, or any other operation that incurs costs.
Cost Pools: Once activities are identified, costs are grouped into ‘cost pools’ based on the resources used to perform these activities. For instance, cost pools might include machinery costs, employee wages, utilities, or any other expenses related to specific activities.
2. Cost Drivers and Allocation:
Assigning Costs: ABC focuses on determining the cost drivers associated with each activity. Cost drivers are the factors that directly cause costs to be incurred. For example, the number of machine-hours, labor hours, setup times, or the number of orders might serve as cost drivers for respective activities.
Allocation of Costs: Once cost drivers are identified, the costs from the respective pools are allocated to the products or services based on the usage of these cost drivers.
The activity cost drivers can broadly be classified into the following three categories:
A. Transaction drivers
B. Duration drivers
C. Intensity drivers.
Following are some of the examples of cost drivers:
i. Machine setups
ii. Material receipts
iii. Machine time
iv. Power consumed.
v. Kilometers driven.
vi. Computer-hours logged.
3. Benefits of Activity-Based Costing:
Accuracy: ABC offers a more accurate representation of costs associated with specific products or services, as it considers the actual activities and resources consumed.
Cost Control: It helps in identifying areas where costs can be reduced by better managing activities and resources.
Decision-Making: Provides better insights for pricing strategies, product mix decisions, and resource allocation.
4. Implementation:
Data Collection: Detailed data collection is necessary to understand and allocate costs accurately to activities and products.
Software Support: Specialized software is often used to handle the complexity of the calculations and to manage the vast amount of data involved in ABC.
5. Challenges of Activity-Based Costing:
Complexity: Implementing and managing ABC can be complex and time-consuming, requiring detailed analysis of activities and resources.
Costly Implementation: The process of implementing and maintaining an ABC system can be expensive.
Resistance to Change: Sometimes, traditional accounting systems and employees might resist transitioning to ABC due to its complexities.
Illustrative examples
In this hypothetical example of XYZ Manufacturing Company we see how the ABC costing is different from traditional costing technique.
Illustration 1
XYZ Manufacturing Company produces two types of products: Product A and Product B. The company uses a traditional costing system and wants to switch to ABC costing to better understand the true cost of each product.
Traditional Costing:
In a traditional costing system, costs are often allocated based on a single cost driver, such as direct labor hours or machine hours. Let’s say XYZ Manufacturing uses direct labor hours as the cost driver. The total overhead costs for the year are $500,000, and the total direct labor hours are 10,000.
The calculation for the overhead rate would be:
Overhead Rate= Total Overhead Costs / Total Direct Labor Hour
Overhead Rate =$500,000/10,000 hours = $50/hour
Now, if Product A takes 5 hours to produce and Product B takes 10 hours, the overhead costs allocated to each product would be:
Product A Overhead Cost=5 hours×$50/hour=$250
Product B Overhead Cost=10 hours×$50/hour=$500
Activity-Based Costing (ABC):
Now, let’s consider ABC costing, where costs are allocated based on the specific activities that drive those costs. XYZ Manufacturing identifies two main activities contributing to overhead costs: machine setup and product testing.
Machine Setup:
Total machine setup costs for the year: $200,000
Total number of setups for Product A: 20
Total number of setups for Product B: 30
Cost per Setup= Total Machine Setup Costs/ Total Setups
Cost per Setup= $200,000 / 20+30 = $2,000/setup
Product A Machine Setup Cost=20 setups×$2,000/setup=$40,000
Product B Machine Setup Cost=30 setups×$2,000/setup=$60,000
Product Testing:
Total testing costs for the year: $300,000
Total testing hours for Product A: 100
Total testing hours for Product B: 150
Cost per Testing Hour= Total Testing Costs / Total Testing Hours
Cost per Testing Hour= $300,000 /100+150 = $1,000/hour
Product A Testing Cost=100 hours×$1,000/hour=$100,000
Product B Testing Cost=150 hours×$1,000/hour=$150,000
Total Costs for Products A and B:
Product A Total Cost (ABC) = Direct Materials + Direct Labor + Machine Setup Cost + Testing Cost
Product B Total Cost (ABC) = Direct Materials + Direct Labor + Machine Setup Cost + Testing Cost
By adopting ABC costing, XYZ Manufacturing now has a more accurate representation of the costs associated with producing each product, as it considers the specific activities that drive those costs. This information can be valuable for pricing decisions, process improvements, and resource allocation.
Where ABC technique is beneficial?
In summary, ABC technique is especially beneficial in industries where overhead costs form a significant portion of the total costs, where products are diverse, or when accurate cost information is crucial for decision-making. While it may be more complicated to implement than traditional costing methods, the benefits of a more accurate cost analysis often outweigh the challenges for many companies.
