Activity Based Costing27th February 2021
ABC costing focuses on identifying activities, or production processes, that are used to process a job. These individual activities are grouped together with similar processes into a cost pool that relates to single activity cost driver.
The cost pools are then analyzed and assigned a predetermined overhead rate that will eventually be assigned to individual jobs and products.
As you can see, this is a multi-step process, but activity-based costing is a much more accurate way of assigning indirect costs. It’s difficult to determine how much electricity or heat one department or job uses over another without some type of methodical allocation process.
Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. Therefore, this model assigns more indirect costs (overhead) into direct costs compared to conventional costing.
CIMA, the Chartered Institute of Management Accountants, defines ABC as an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs.
The Institute of Cost & Management Accountants of Bangladesh (ICMAB) defines activity-based costing as an accounting method which identifies the activities which a firm performs and then assigns indirect costs to cost objects.
Activity based costing helps allocate overhead expenses to jobs and products based on the amount of the activities required to produce the product instead of simply estimating how much each job uses.
Properly assigning indirect costs is extremely important for management, especially in the case of downsizing or outsourcing. Profitable departments can be assigned too much indirect cost causing them to appear unprofitable on paper. Based an evaluation management can choice to discontinue the operations and close a profitable branch because the costs were properly distributed.
To compound the problems, once the profitable branch is closed the only remaining branches are the unprofitable ones. By shutting down the only profitable department, the company may not be able to cover its fixed costs.
The same scenario is true for outsourcing. Management may estimate outsourcing to be a cheaper option because costs have not been allocated properly. In fact, outsourcing might actually be more expensive.
- Identify and eliminate those products and services that are unprofitable and lower the prices of those that are overpriced (product and service portfolio aim), or
- Identify and eliminate production or service processes which are ineffective, and allocate processing concepts that lead to the very same product at a better yield (process re-engineering aim)
- Is applicable throughout company financing, costing and accounting:
- Is a modeling process applicable for full scope as well as for partial views?
- Helps to identify inefficient products, departments and activities.
- Helps to allocate more resources on profitable products, departments and activities.
- Helps to control the costs at any per-product-level level and on a departmental level.
- Helps to find unnecessary costs that may be eliminated.
- Helps fixing the price of a product or service with any desired analytical resolution.
- Identify and assess ABC needs: Determine viability of ABC method within an organization.
- Training requirements: Basic training for all employees and workshop sessions for senior managers.
- Define the project scope: Evaluate mission and objectives for the project.
- Identify activities and drivers: Determine what drives what activity.
- Create a cost and operational flow diagram: How resources and activities are related to products and services.
- Collect data: Collecting data where the diagram shows operational relationship.
- Build a software model, validate and reconcile.
- Interpret results and prepare management reports.
- Integrate data collection and reporting.
- Identify costs. The first step in ABC is to identify those costs that we want to allocate. This is the most critical step in the entire process, since we do not want to waste time with an excessively broad project scope. For example, if we want to determine the full cost of a distribution channel, we will identify advertising and warehousing costs related to that channel, but will ignore research costs, since they are related to products, not channels.
- Load secondary cost pools. Create cost pools for those costs incurred to provide services to other parts of the company, rather than directly supporting a company’s products or services. The contents of secondary cost pools typically include computer services and administrative salaries, and similar costs. These costs are later allocated to other cost pools that more directly relate to products and services. There may be several of these secondary cost pools, depending upon the nature of the costs and how they will be allocated.
- Load primary cost pools. Create a set of cost pools for those costs more closely aligned with the production of goods or services. It is very common to have separate cost pools for each product line, since costs tend to occur at this level. Such costs can include research and development, advertising, procurement, and distribution. Similarly, you might consider creating cost pools for each distribution channel, or for each facility. If production batches are of greatly varying lengths, then consider creating cost pools at the batch level, so that you can adequately assign costs based on batch size.
- Measure activity drivers. Use a data collection system to collect information about the activity drivers that are used to allocate the costs in secondary cost pools to primary cost pools, as well as to allocate the costs in primary cost pools to cost objects. It can be expensive to accumulate activity driver information, so use activity drivers for which information is already being collected, where possible.
- Allocate costs in secondary pools to primary pools. Use activity drivers to apportion the costs in the secondary cost pools to the primary cost pools.
- Charge costs to cost objects. Use an activity driver to allocate the contents of each primary cost pool to cost objects. There will be a separate activity driver for each cost pool. To allocate the costs, divide the total cost in each cost pool by the total amount of activity in the activity driver, to establish the cost per unit of activity. Then allocate the cost per unit to the cost objects, based on their use of the activity driver.
- Formulate reports. Convert the results of the ABC system into reports for management consumption. For example, if the system was originally designed to accumulate overhead information by geographical sales region, then report on revenues earned in each region, all direct costs, and the overhead derived from the ABC system. This gives management a full cost view of the results generated by each region.
- Act on the information. The most common management reaction to an ABC report is to reduce the quantity of activity drivers used by each cost object. Doing so should reduce the amount of overhead cost being used.
Activity-Based Costing Formula = Cost Pool in Total / Cost Driver
The ABC formula can be explained with the following core concepts.
Cost Pool: This is an item for which measurement of the cost would require, e.g., a product
Cost Driver: It is a factor that will cause a change in the cost of that activity. There are two kinds of cost driver:
Resource Cost Driver: It is a measure of the number of resources that shall be consumed by an activity. This will be used to assign the cost of a resource to an activity. E.g., Electricity, Staff wages, Advertising, etc.
Activity Cost Driver: This is the measure of the intensity of demand and the frequency that is placed on the activities by the cost pools. It will be used to assign the activity costs to a product or a customer. E.g., Material ordering costs, Machine set up costs, Inspection and testing charges, Material handling and storing costs, etc.
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