Activity-Based Costing ABC: Method and Advantages Defined with Example

Similarly, a customer may be identified as a low value customer because of loss from transactions with him according to strategic ABM. Managers can set cost reduction targets in terms of reducing the cost per

activity based costing

Similarly, a customer may be identified as a low value customer because of loss from transactions with him according to strategic ABM. Managers can set cost reduction targets in terms of reducing the cost per unit in relation to cost allocation base in different activities areas. For instance, a manager may aim at reducing cost of transporting the product from Rs. 5 per unit to Rs. 4.50 per unit.

Activity-Based Costing (ABC) Principles, History & Steps FAQs

An activity-based costing system, when used in conjunction with a Lean project management methodology such as kanban, can help companies cut down on wasteful processes that suck up time, resources and money. Now that you have determined your cost drivers (items that cost you money), you can break them down into cost pools (groups of resources). For example, we can take the utility cost driver and break it down into a cost pool that contains electric, gas, water and waste disposal bills. By doing this, you can see precisely what in each activity will hit your bottom line.

Implementing ABC Activity Based Costing in Your Organization

  • ABC activity-based costing plays a significant role in shaping business strategy, primarily through its influence on pricing and decision-making.
  • Nowadays production processes are far more complex where direct labour costs are insignificant as compared to total costs.
  • Further, assume your ice cream issold only in one liter containers, while your friend sells icecream in various containers.
  • Activities consume overhead resources and are considered cost objects.

For example,if we find that a jacket requires too many costly inspections, wecould redesign the jacket to reduce the need for inspections. Ourcurrent cost system allocates all overhead costs, includinginspection costs, to products based on machine-hours. We really donot know how much it costs to make an inspection and how muchinspection cost is required by each product. We will use this company as abasis to demonstrates important issues about the difficulty withtraditional cost allocation methods and the advantages ofactivity-based costing. Back to where we started, with the never-ending balancing act of pricing your products.

The Impact of ABC Activity Based Costing on Business Strategy

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. This is because some activities may have an implicit value but may not be reflected in the financial value added to the product.

activity based costing

activity based costing

Moving from a traditional system to an ABC system is a big undertaking that will require many hours of research, setting up software to track expenses and maintenance. It’s such a big undertaking that you need to hire a dedicated finance manager to keep up with everything. Fortunately, there are tools out there that can make switching to an ABC system easier.

activity based costing

Step 1: Identifying the Activity Cost Pool

Look at the overhead rates computed for the fouractivities in the table below. Note that the total overhead forcurrent year is $2,000,000 using activity-based costing, just as itwas using a traditional costing method. The total amount ofoverhead should be the same whether using activity-based costing ortraditional methods of cost allocation to products. In practice, companies using activity-based costing generallyuse more than four activities because more than four activities areimportant.

Improved cost control

  • CIMA defines ABC as, “Cost attribution to cost units on the basis of benefit received from indirect activities”.
  • The levels are (a) unit level, (b) batch level, (c) product level, and (d) facility level.
  • Step 1 is often the most interesting andchallenging part of the exercise.
  • If you add up the salaries of each worker,  you get the total salary of all the workers, which is called the cost pool.
  • Thus, cost driver is a factor or an event which results in consequential change in the total cost of the object.

A financial professional will offer guidance based on the information provided and offer a no-obligation call to better understand your situation. A cost element refers to an account which receives and accumulates costs over a period of time. It also includes the revenue accounts that receive and accumulate revenues over a period of time. When employees understand the activities they perform, they can better understand the costs involved.

What are the steps involved in an Activity-Based Costing system?

The point is that skill is required to interpret any costing information. Traditional and activity-based costing systems are similar in that they’re both used to assign overhead costs to products. A traditional costing method assigns costs to products via one cost driver, such as labor. As you can imagine, using just one cost driver can lead to inaccurate cost measurements. With the cost pools and drivers in place, the next step is to calculate the cost driver rates for each cost pool. This can be done by dividing the total overhead cost of each cost pool by the total number of cost drivers.

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. Compared to traditional costing methods, the ABC system of cost accounting is much more complicated. No more general overhead costs and activities – you have to be specific. Activity-based costing is a more specific way of allocating overhead costs based on “activities” that actually contribute to overhead costs. In job-order costing and variance analysis, overhead costs are applied based on a specific cost driver such as labor hours or machine hours.

Leave a Reply

Your email address will not be published. Required fields are marked *