Introduction to Activity Based Costing
Activity-based costing, also known as ABC, is considered an alternative approach to Product costing. Activity Based Costing allocates the overheads to the cost pools before absorbing them into units using cost drivers. A cost pool is an activity that consumes the resources for which the overheads are identified and then allocated. Each cost pool has a cost driver with it. It has been developed and adopted by the industry to overcome the limitations of the traditional costing method.
Explanation
Activity Based Costing is being introduced to solve the costing problems associated with the traditional costing method. It divides the overheads into different cost pools and then allocates them. It identifies the activities in the organization, such as the purchase of material is an activity of purchase requisition, and follow up from the suppliers of the product delivery is also an activity. It helps to divide the true overheads into the proper place, thus making the costing system more accurate. It helps to formulate the appropriate marketing and corporate strategy. Cost allocation is done more accurately; therefore, each product’s cost is fairer.
Objectives of Activity Based Costing
The main objective of introducing Activity Based Costing is that the traditional costing method had some limitations due to which the cost of the product was not accurately calculated. Thus it was affecting the cost per unit of the product. In the traditional costing method, the overheads were allocated arbitrarily; sometimes, the allocation was done based on the production volume, which is not a correct method of giving the cost. Therefore, the Activity Based Costing method was introduced. In an organization, the Activity Based Costing method helps to control the cost because the cost is measured accurately due to fairer distribution of the overheads.
How does it Work?
It works as per the steps mentioned below.
- Step 1 – Find out the activity related to the production overhead.
- Step 2 – Identify the cost drivers for each and every activity.
- Step 3 – Calculate the cost driver rate of the activity.
- Step 4 – Absorption of activity into the product.
- Step 5 – Now calculate the production cost.
- Step 6 – Find out the profit and loss.
Example of Activity Based Costing
Otis worldwide corp is a company that produces 2 items A and B.
- Total Quantity- A- 1000, Total Quantity – B- 2000
- Direct Material A-$5/unit. Direct Material B-$ 6/unit.
- No. of purchase requisition-A- 120, No. of purchase requisition B- 180.
- Production Overhead-$10,000. It is segregated into two departments’ equally, i.e. Inspecting, and Production Set up.
- No. of batches received for inspection = 50.
- No. of batches received for production setup = 80.
Solution:
We are required to find out the cost per unit as per the ABC method.
Cost Drivers Rate for A
Cost Drivers Overhead Rate is calculated as:
Cost Drivers Rate = Inspection Department Overhead / No. of Batches to Be Inspected
| Inspection department overhead | 5000 |
| No. of batches to be inspected | 50 |
| Cost Driver Rate | 100 |
Cost Drivers Rate for B
Cost Driver Rate is calculated as
Cost Driver Rate = Production Set up / No of Batches Received for Production Setup
| Production Set up. | 5000 |
| No. of batches received for production setup | 80 |
| Cost driver rate | 62.5 |
| Particulars | A | B |
| Direct Material | 5 | 6 |
| Overhead | ||
| Inspection | 12 | 9 |
| Production Set up. | *7.5 | 5.625 |
| Total cost per unit | **24.5 | 20.625 |
- *(Cost driver of Inspection*No. of purchase requisition) / Total quantity.
- ** (Cost driver of Production Setup*No. of purchase requisition) / Total quantity.
Uses of Activity Based Costing
- Better allocation of overhead is done by using the Activity Based Costing.
- It also controls the cost.
- The cost drivers are identified, and then the allocations of overheads are made.
- The cost per unit calculation is done more accurately.
Application of Activity Based Costing
It is applied mostly in big companies where the overheads are too much and cannot be allocated in a single overhead activity. It is used mostly in complex situations where the cost allocation requires some expertise. Since cost drivers are required to be found out, it is mainly used in the service sector, where cost allocation becomes a challenge.
Advantages
Some of the advantages are given below:
- It is more accurate and reliable than traditional costing methods.
- In Activity Based Costing, the proper allocation of overheads is done, which helps to find out the correct cost per unit of the product.
- It helps to subside the limitation of a traditional method.
- It helps in a capital investment decision.
- Market research becomes easy if we opt for Activity Based Costing.
- Activity Based Costing also helps in decision making by the management of the company.
- Measuring the cost drivers and then allocating can help the management to get fair and easy pricing.
Disadvantages
Some of the disadvantages are given below:
- It has been seen that Activity Based Costing can sometimes be irrelevant, especially in those cases where the overhead allocation is not done properly.
- Sometimes the cost allocation is done arbitrarily or by taking certain assumptions.
- Expert knowledge is required in case the company follows the Activity Based Costing method since it can be difficult to identify the cost drivers followed by the allocation, and thus the cost per unit calculation can be affected very badly.
- The Activity Based Costing is also somewhat expensive because the cost of hiring an expert to carry on the process can be a bit higher.
Conclusion
Activity Based Costing is a method that companies use to arrive at an accurate cost or price of the product. It is a very effective tool and can help the organization reach a fair allocation of the overheads. Cost pool and cost drivers are taken care of in this method. This method can be very budget-friendly if used properly. It is better than the traditional method in many ways, and to overcome the limitation of the traditional method, this Activity Based Costing method is being introduced. Activity Based Costing helps in the decision making of the management.
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