Activity Based Costing Accounting

what is activity based costing

ABC works best in complex environments, where there are many machines and products, and tangled processes that are not easy to sort out. Conversely, it is of less use in a streamlined environment where production processes are abbreviated, so that costs are easy to assign. As an activity-based costing example, consider Company ABC that has a $50,000 per year electricity bill. The number of labor hours has a direct impact on the electric bill. 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. An activity is defined as a process, function, task, or step that occurs over time and generates results that the company uses to produce and sell its products and services.

  • While waiting for credit reports (a non-value-added activity), perhaps the bank can find other value-added activities that bank personnel can perform (e.g., responding to customer questions or processing other loan applications).
  • Using this activity-based costing system will give management a more accurate product cost.
  • But in case of ABC, set up and adjustment time is determined for each department and its cost is directly charged to each department.
  • This approach is different from traditional costing, which assigns the cost of products and services to overhead cost pools and then calculates the cost of products and services using an allocation rate.
  • Activity-based costing and activity-based management techniques are not limited to manufacturing companies.
  • Hence, there is a need for more systematic and accurate system for cost ascertainment and cost control.

However, maybe they are then actually being produced in huge batches, so actually, when it comes to things like equipment setups and material movements, the product is less of a burden. First of all, in a modern manufacturing environment, overheads tend to be a much bigger proportion of total production costs. In traditional manufacturing environments, the largest proportion of costs tended to be related to direct costs. Therefore, with the workers on the production line actually piecing together the different material parts of the vehicle, the vast majority of costs for Ford in that traditional factory environment were direct costs.

What Are The Advantages And Disadvantages Of Activity

That means, overhead expenses are initially identified with the cost centres (i.e., departments, divisions, branches, etc.) and then, they are identified with, and charged to, the products. It may be noted here that the prime costs are identified with, and charged directly to, the products. Generally, the products are cost objects, but the customers, services or locations can also be the cost objects. The management does not find these traditional methods helpful in making complicated decisions related to product strategies. Predetermined Overhead Rate FormulaPredetermined Overhead Rate is that rate that is used to calculate an estimate on the projects which are yet to commence for overhead costs. It would involve calculating a known cost and then applying an overhead rate to project an unknown cost .

what is activity based costing

This would give an inaccurate representation of the cost of the product or service. 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. But while that distribution did reflect how workers spent their productive time, the fact that their total productive time was significantly less than their practical capacity of 32 hours per worker per week was completely ignored. 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. This means that $200,000 will first be allocated to batches of products to be manufactured , and then be assigned to the units of product in each batch .


Since we already know the cost of supplying capacity—the $560,000 in overhead costs—we can now calculate the cost per minute of supplying capacity ($0.80). Explicit cost driver- explicit cost drivers are those which are included in the accounting records of an organization at the time of preparing Financial Statements. These include items such as salaries, raw material consumption etc. Implicit cost drivers- Implicit cost drivers are not recorded in the accounting records of an organization during the preparation of Financial Statements. From the above analysis, it is clear that the Traditional Absorption Costing Method and Activity-based Costing Method show different cost results. Under the traditional absorption costing method, Product ‘R’ is more expensive while under activity-based costing method, product ‘P’ is more expensive. Assign costs to products by multiplying the cost driver rate times the volume of cost drivers consumed by the product.

  • The following details pertain to different activities and their costs for Gamma Ltd.
  • With activity-based costing, product-focused businesses can get into the nitty-gritty details to better allocate expenses.
  • Setting-up of an information system which could help trace all the costs to cost objects.
  • Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate.
  • This provides the business with better information to make value-based and therefore more effective decisions.
  • The differences are in the accuracy and complexity of the two methods.
  • This validation is difficult with traditional ABC, which is based on estimated proportions of time spent and rarely incorporates idle or unused capacity time.

As a result, now many US Corporations are also increasingly adopting Activity Based Costing. It would be difficult to correlate the marginal increase in cost with a particular cost driver. Where selling prices are fixed on the basis of cost plus formula, ABC provides more reliable data for fixing selling prices.

Calculate Cost Of Distribution Channels

The number of activities a company has may be small, say five or six, or number in the hundreds. Assume Lady Trekkers, Inc., has identified its activity cost pools and cost drivers .

  • Each activity-based costing rate is then multiplied by the cost driver activity for that specific product to solve for the amount of overhead allocated to that specific product.
  • Clearly, there are many valuable uses for the information provided by an ABC system.
  • In this way, according to Professor Kaplan, in an article he wrote for The CPA Journal in 1990, “ABC offers management accurate information by delineating support costs and tracing them to individual products and product lines.”
  • For the activity reviewing customer applications, the calculation results in a rate per application reviewed, and for running credit reports, a rate per credit report run.
  • Identify and assess ABC needs – Determine viability of ABC method within an organization.
  • Where selling prices are fixed on the basis of cost plus formula, ABC provides more reliable data for fixing selling prices.

The energy and utility sectors can answer their business needs using the software. The first thing a business must do when using ABC is set up a team charged with determining which activities are necessary for the product or service in question. This team needs to include experts from different areas of the company ; an outside consultant may also be helpful. Implementing an activity-based costing program requires planning by and a commitment from upper management. If possible, it is best to do a trial study or test run on a department whose profit-making performance is not up to snuff. These types of situations have a greater chance of succeeding and demonstrating that an ABC program is worth the effort.

What Are The Steps Of Activity

Such expansion has caused ABC systems to exceed the capacity of generic spreadsheet tools, such as Microsoft Excel, and even many ABC software packages. For example, the automated ABC model for Hendee Enterprises, a $12 million fabricator of awnings, took three days to calculate costs for its 40 departments, 150 activities, 10,000 orders, and 45,000 line items. According to an estimate, the normal overhead rate which was 200% to 300% of direct costs about 15 years ago, has gone up to 500% to 800%. The traditional methods applied for absorbing overheads lay emphasis on the calculation and application of overhead recovery rates which are acceptable for the valuation of stocks for the purposes of routine financial reporting. The management is not able to find these different traditional methods of costing that may be helpful in making some hard decisions which may affect the product strategies. Like manufacturing industries, financial institutions have diverse products and customers, which can cause cross-product, cross-customer subsidies. Since personnel expenses represent the largest single component of non-interest expense in financial institutions, these costs must also be attributed more accurately to products and customers.

what is activity based costing

Helps to control the costs at any per-product-level level and on a departmental level. Lean accounting methods have been developed in recent years to provide relevant and thorough accounting, control, and measurement systems without the complex and costly methods of manually driven ABC. The broad range of issues noted here should make it clear that ABC tends to follow a bumpy path in many organizations, with a tendency for its usefulness to decline over time. Of the problem mitigation suggestions noted here, the key point is to construct a highly targeted ABC system that produces the most critical information at a reasonable cost. If that system takes root in your company, then consider a gradual expansion, during which you only expand further if there is a clear and demonstrable benefit in doing so. The worst thing you can do is to install a large and comprehensive ABC system, since it is expensive, meets with the most resistance, and is the most likely to fail over the long term.

What Is The Activity Based Costing?

If this company used traditional costing, it might allocate or “spread” all of its overhead to products based on the number of machine hours. This will result in little overhead cost allocated to Product 124, because it did what is activity based costing not have many machine hours. However, it did demand lots of engineering, testing, and setup activities. In contrast, Product 366 will be allocated an enormous amount of overhead , but it demanded little overhead activity.

what is activity based costing

Its overall objective is to improve efficiency and effectiveness of an organization in securing its markets. It depends heavily on Activities Based Costing as a source of its information. Non-financial information regarding quality flexibility and value to the customer can be received. For example, PCB Ltd. is manufacturing circuit board for computer monitor, TV and aeroplane. However, the circuit board for the aeroplane is tested for a longer time by highly paid technicians because it must be 100% error-free. ABC is based on George Staubus Activity Costing and Input-Output Accounting.

Activitybased Costing

Managers can review the cost of the unused capacity and contemplate actions to determine whether and how to reduce the costs of supplying unused resources in subsequent periods; they can then monitor those actions over time. In some cases, the information can save companies that are considering expansion from making unnecessary new investments in capacity. For example, the vice president of operations at Lewis-Goetz, a hose and belt fabricator based in Pittsburgh, saw from his time-driven ABC model that one of his plants was operating at only 27% of capacity. Rather than attempt to downsize the plant, he decided to maintain the capacity for a large contract he expected to win later that year, for which he otherwise would have created new capacity. Traditional ABC models also often fail to capture the complexity of actual operations. In addition, the order may be entered into the system either manually or electronically, and it may be either a standard or an expedited transaction. To allow for the significant variation in resources required by the different shipping arrangements, new activities must be added to the model, thereby expanding its complexity.

For example, a product with few set-ups, material movements or inspections will have lower costs under ABC than traditional absorption costing. The organisation could decide to reduce the product’s selling price but if it is a high volume product, the number of units sold may not increase sufficiently to compensate for the loss in total revenue and contribution.

Identify Profitable Customers

There is a very high probability of an ABC system providing a different picture of product costs than what is provided by the traditional system. However, since both methods make assumptions about the behaviour and cause of costs, it cannot be said with certainty that ABC shall always produce more precise results than traditional costing. Activity Based Costing establishes relationship between overheads costs and activities in order to ensure that the overheads costs are more precisely allocated to products, services or customers segments. While Activity Based Management focuses on managing activities, reducing costs and improving customer value. Cost of activity will be charged to the product using cost driver rate according to the requirement of activities of each product. For instance, a product may require 10 machine setups and 1 inspection related activity. Thus, product will be charged for both machine related set up activity cost and inspection activity cost.

Cost driver – activities performed in a business that are positively correlated with costs. Cost drivers are most often used in the allocation of cost pools to cost objects. Activity-based costing takes into account the resources that are used to produce a product or service. ABC assigns a cost to each activity and then assigns the cost of each activity to the products or services that are generated by that activity. This approach provides a more accurate representation of the cost of a product or service.

Activity Based Costing Steps

The ever increasing and severe market competition due to globalization has increased the necessity of more accurate product costs in order to avoid the disadvantages of under-costing and over-costing. As the company gathers more information about its processes and their influence on the company’s products, services, clients and channels, it will be able to make more assertive decisions. This provides each manager with more tools to manage the team’s costs as well as information to audit and analyze these costs. The efficiency of this costing methodology is in its ability to provide a logical tracing of costs. The fact that it isn’t linked to the timing of each process makes it possible for ABC costing to identify each expense and designate it as part of a specific activity.

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