Activity-Based Costing

Integrating Eva And Process Based Costing

Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities. The first step in Activity-Based Costing is to divide the expenses of certain overhead activities to a per-event cost. For example, say that the overall cost of resetting a machine for production during the year was $1 million.

Transition To Automated Activity-based Costing Accounting

As a result, the firm will have to uncover indirect product costs through a costing methodology—either traditional cost allocation or activity-based costing. ABC contrasts with traditional costing (cost accounting), which sometimes assigns costs using somewhat arbitrary allocation percentages for overhead or the so-called indirect costs. As a result, ABC and traditional cost accounting can estimate the cost of goods sold and gross margin very differently for individual products. Contradictory and uncertain cost estimates can be a problem when management needs to know precisely which products are profitable and which are selling at a loss. Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours.

Traditional Vs. Activity-based Costing

Who invented Activity Based Costing?

Activity-based costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions. ABC enables effective challenge of operating costs to find better ways of allocating and eliminating overheads. It also enables improved product and customer profitability analysis.

In the case of our customer service department, the traditional ABC survey produced a work distribution of 70%, 10%, and 20% of the employees’ time performing the department’s three activities. The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level cost. For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units). If Batch Y is 50,000 units, the cost per unit for setup will be $0.01 ($500 divided by 50,000 units).

What Is Activity-based Costing (Abc)?

Activity-Based Costing

What are the costing methods?

Robert Kaplan is regarded as the founder of the theoretical principles of activity based costing within the cost management knowledge area. In the 1970s the activity based costing method was introduced in the manufacturing industry to solve the problems of traditional cost price calculation.

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. Employees who adjust and maintain production equipment, but who do not work directly on individual product units are indirect labor. Activity-based costing assigns values to indirect labor and materials by measuring activities and the resources they consume.

Activity-Based Costing

You have two products and you had to switch the machine over 100 times. The first stage of allocation would stipulate that the cost of one setting switch is $10,000 . Absorption-costing, or full costing, has for years been the most common method of allocating manufacturing overhead.

Activity-Based Costing

  • As a result of the ABC process, companies are better able to manage manufacturing performance and improve the quality of products and services.
  • Overall, profitability is increased as a result of more accurate product pricing which can allow companies to offer competitive pricing while maximizing their returns.
  • They can then streamline these processes by allocating more resources to profitable activities and eliminating practices that are costly and wasteful.

For the year, there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. , overhead costs are applied based on a specific cost driver such as labor hours or machine hours.

For example, cutting raw materials consumes labor and machine hours. Likewise, moving heavy materials in a factory consumes resources (costs) such as employee time for driving a forklift, the electricity to power the forklift, and the wear and tear on a forklift. Also, training employees causes costs to be incurred such as fees or salaries paid to trainers and the training supplies used. In contrast, Activity-Based Costing focuses on activities and the costs of carrying out activities.

In addition to the financial benefits to the organization, Chrysler has become a teacher and innovator for other organizations looking to apply ABC methods into their accounting practices. They even sponsor their own five-day Core Competency Course, which has been attended by over 600 people. Management Activity-Based Costing must estimate the profitability of each product to decide which products to produce and sell and how to price them. These estimates, in turn, require an understanding of the full cost per unit of each product. While the direct costs per unit are easy to find, the indirect costs are less noticeable.

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 these potential activities instead of relying on just one variable (either labor hours or machine hours). These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity. Direct labour and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process.

Activity-based costing (ABC) attempts to more accurately assign overhead costs Days Sales Outstanding to the users of overhead by focusing on activities. The basic principle underlying activity-based costing is that an activity, which is a task, operation, or procedure, is what causes costs to be incurred.

Activity-Based Costing

Further, assume your ice cream is sold only in one liter containers, while your friend sells ice cream in various containers. Your friend has more complicated ordering, storage, product testing (one of the more desirable jobs, nevertheless), and packing in containers. Presumably, you can set the machinery to one setting to obtain the desired product quality and taste.

After overcoming internal resistance, training team members and enduring initial failures, they were able to successfully implement ABC throughout the organization. Since its implementation, Chrysler estimates that ABC has helped generate hundreds of millions of dollars for the corporation by initiating simplified product designs and eliminating redundant and unproductive activities. This represents returns that are ten to twenty times greater than the company’s investment and implementation costs of the ABC program.

How do you calculate Activity Based Costing?

The main costing methods available are process costing, job costing and direct costing. Each of these methods apply to different production and decision environments. The main product costing methods are: Job costing:This is the assignment of costs to a specific manufacturing job.

But ABC may use a multitude of cost drivers that relate costs more closely to the resources consumed and activities occurring. There are no simple rules that pertain to the selection of cost drivers. Traditionally, in a job order cost system and process cost system, overhead is allocated to a job or function based on direct labor hours, machine hours, or direct labor dollars. In such companies, activity‐based costing (ABC) is used to allocate overhead costs to jobs or functions. In 1991, the major automobile manufacturer Chrysler introduced activity-based costing as part of their accounting practices.

Rates based on these activities are then used to assign overhead to products in proportion to the amount of activity required to produce them. Activity-based costing typically uses more overhead allocation rates than the plantwide and departmental methods. ABC focuses attention on cost drivers, the activities that cause costs to increase. Traditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received.

The cost driver is a factor that creates or drives the cost of the activity. For the activity of running machinery, the driver is likely to be machine operating hours, looking at labor, maintenance, and power cost during the period of machinery activity. One of the lessons of activity-based costing has been that the more complex the business, the higher the indirect costs. Imagine that each month you produce 100,000 gallons of vanilla ice cream and your friend produces 100,000 gallons of 39 different flavors of ice cream.

This approach takes the full amount of manufacturing overhead and spreads it equally across the production volume of all products. It does not consider that certain products may be responsible for more or fewer costs from specific activities. Activity-based costing, also known as ABC, deals with this problem.

For simplicity, let’s assume that the remaining $1,800,000 of manufacturing overhead is caused by the production activities that correlate with the company’s 100,000 machine hours. In traditional product costing, the number of cost drivers used are few such as direct labour hours, machine hours, direct labour cost, units produced.