Activity-Based Costing Definition, Process, & Example

Nowadays, it just simply isn’t the case that if something’s produced in a larger volume, it necessarily places bigger demands on the business in every single area of the production process. So, actually, if we have overheads that behave in different ways, we need to understand that behaviour, so we can hopefully work out an accurate cost. However, once again, it’s the case that in a modern manufacturing environment, the production process is so complex, that we’ve got loads of overheads; but not all of them are fixed, certainly not over the medium to long term. Within this context, MyABCM’s software has been developed to provide management based on activities, favoring cost control and your business’s return on investment. Many companies already possess a costing mechanism that uses spreadsheets.

Support overheads are charged to products on the basis of their usage of an activity. An activity is an event, task, or unit of work with a specific purpose, whether it be designing products, setting up machines, operating machines, or distributing products. Therefore, activity-based costing considers all the potential activities instead of relying on just one variable . Mamata Inc., a manufacturing https://www.bookstime.com/ company of drugs, is considering switching from its traditional cost method to a newly implemented system by their production head. It is activity-based costing so that the two products, Z serum, and W serum, can be sold at their reasonable cost and make them price competitive in the market. Overheads, while they still existed, were a relatively small proportion of what Ford’s production costs were.

Activity-based costing vs. traditional costing

Thus, using a system like the MyABCM solution surpasses the activity and cost management capabilities of any other software. Once the costs of the activities have been determined, the organization can begin to manage them and question why each is affecting the costs of the company’s various products, clients, channels and services. At the same time, this system makes the costing process more accurate and precise. Activity-based costing is more complicated than traditional costing.

It may be noted here that the prime costs are identified with, and charged directly to, the products. activity based costing The Activity Based Management system provides information and data on activity performance.

Activity Based Costing with Two Activities

The cost driver rate could be the cost per purchase order, for example. Activity cost driverAn activity cost driver is measuring the frequency and the demand by the cost items. Using activity-based costing helps to set the pricing strategy more accurately. ABC provides more reliable data relating to activity driving costs which helps managers to improve product and process value. ABC has helped enterprises in answering the market need of better quality products at competitive prices. Ascertaining the product profitability and customer profitability, the ABC method has contributed effectively for the top management’s decision-making process. For instance, pleasant work place may not be identified as an activity adding value according to operational activity based management.

• If a company does not operate in such an environment, then it may spend a great deal of money on an ABC installation, only to find that the resulting information is not overly valuable.
• The model also captured the extra packaging costs for special promotions and customer-specific labels and promotions.
• However, some managers reject this methodology as conceptually flawed.
• Activity-based costing is a method of identifying a company’s indirect cost activities and assigning these costs to the products or jobs that use these activities.

For a single-product company with fairly stable inventory levels, traditional and ABC methods will yield about the same results. But, for multi-product/service firms, the arbitrary allocation of costs can pretty much “make or break” the perceived profitability of each product or service. As companies have grown larger and more diverse in output, there has been an accompanying concern about how costing occurs. Arguably, product diversification has been a major contributing factor to the management accountant’s pursuit of alternative costing methods like ABC. The fact that ABC is not GAAP usually means that a company that wishes to benefit from ABC must develop one costing system for external reporting and another for internal management. Another disadvantage of ABC is that it is usually more involved than other approaches. Rather than applying all factory overhead on some simple basis such as labor hours, it requires the development of numerous cost pools that must be individually allocated.

Disadvantages of Activity-Based Costing

ABC is based on George Staubus Activity Costing and Input-Output Accounting. The concept of ABC was developed in the manufacturing sector of the United States during 1970s and 1980s.

Non-value added activities, in general, must be eliminated if possible. Each country-level effort has assembled a local steering committee, employed local institutions, and developed an implementation strategy focused on long-term capacity building that leverages existing data systems. While ABC has been used in high-income countries primarily for cost reduction, its application in low-resource settings will likely reveal situations where greater resources are desirable.

Better Reporting – ABC system provides better reporting of cost of activities and their performance which will help in taking suitable decision and in improving efficiency. Where selling prices are fixed on the basis of cost plus formula, ABC provides more reliable data for fixing selling prices. ABC helps managers to identify and control the cost of unused capacity. It facilitates the preparation of an activity-based budget by providing the management with a clear view on the details of various activities. Strategic cost information of which long-term profitability decision for a product can be taken. The final words of comment over ABC system are that adoption, implementation and operation of the system is not an end in itself. The benefits can be derived by translating the system design and its operation into action-oriented managerial performance.

Presumably, you can set the machinery to one setting to obtain the desired product quality and taste. Your friend has to set the machines each time a new flavor is produced. Although both of you produce the same total volume of ice cream, it is not hard to imagine that your friend’s overhead costs would be considerably higher. Once it is known how to calculate activity rate, then costs can be allocated to all products using the cost allocation formula. The cost allocation formula, also known as the activity cost allocation rate formula, is the activity-based costing rate multiplied by the actual cost driver.