Activity Based Costing Explanation

abc costing system

Thus, the larger the number of departments involved in the system, the greater the risk that data inputs will fail over time. This problem can be avoided by designing the system to only need information from the most supportive managers.

abc costing system

Activity-based costing is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing recognizes the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less arbitrarily than traditional costing methods. However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.

The Purpose of Activity-Based Costing

It also enables improved product and customer profitability analysis. It supports performance management techniques such as continuous improvement and scorecards. Unlike traditional cost price systems, activity based costing does establish a causal link between the cost drivers and indirect costs. By passing on this insight to the responsible cost drivers, a transparent and cost-conscious conduct is stimulated. 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. This provides the amount of overhead allocated to the product based on the cost pool.

Overhead costs are not allocated to the products that actually consume the overhead activities. CIMA Official Terminology describes activity-based costing as an approach to the costing and monitoring of activities, which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects. CIMA, the Chartered Institute of Management Accountants, defines ABC as an approach to the costing activity based costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs. Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation, utilities, or salaries—traceable to certain activities.

Comparison of Results Under Both Costing Methods

Ascertaining the product profitability and customer profitability, the ABC method has contributed effectively for the top management’s decision-making process. This is a continuous improvement process in terms of analysing the cost, to reduce or eliminate the non-value-added activities and to achieve an overall efficiency. It may become apparent that costs are not driven solely by output volumes, and, therefore the focus on managerial attention may be significantly broadened. This may encourage managers to adopt a holistic view of the organization. This is because some activities may have an implicit value but may not be reflected in the financial value added to the product. Examples of duration drivers are set-up hours and inspection hours. The final words of comment over ABC system are that adoption, implementation and operation of the system is not an end in itself.

An ABC system rarely can be constructed to pull all of the information it needs directly from the general ledger. Instead, it requires a separate database that pulls in information from several sources, only one of which is existing general ledger accounts.

What is a service level in ABC?

That means you can more accurately analyze your spending—and price your products. An ABC system can sort through these additional overhead costs and help you determine which customers are actually earning you a reasonable profit. This analysis may result in some unprofitable customers being turned away, or more emphasis being placed on those customers who are earning the company its largest profits. Use an activity driver to allocate the contents of each primary cost pool to cost objects. To allocate the costs, divide the total cost in each cost pool by the total amount of activity in the activity driver, to establish the cost per unit of activity.

  • In this example, the overhead charged to the hollow ball using ABC is $0.52 and much higher than the $0.35 calculated under the traditional method.
  • Create cost pools for those costs incurred to provide services to other parts of the company, rather than directly supporting a company’s products or services.
  • Direct labour and materials are relatively easy to trace directly to products, but it is more difficult to directly allocate indirect costs to products.
  • The systems could take days to process one month’s worth of data.
  • A more systematic approach, perhaps, is to review past activity levels and identify the month with the largest number of orders handled without excessive delays, poor quality, overtime, or stressed employees.

Assign costs to products by multiplying the cost driver rate times the volume of cost drivers consumed by the product. Note that when calculating product costs for service organizations, it is difficult, if not impossible, to calculate a product cost per unit. Most service organizations do not have an easily defined unit of measure because services vary so much from one customer to another. One alternative is to calculate total profit as a percent of total sales revenue. This allows for a comparison of profitability between different types of services, similar to comparing the profitability for units of product.

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