Activity-Based Costing (ABC)

What Is Activity-Based Costing (ABC)?

Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services. This accounting method of costing perceives the relationship between costs, overhead activities, and manufactured products, assigning indirect costs to products less randomly than traditional costing methods. Nonetheless, a few indirect costs, for example, management and office staff salaries, are hard to assign to a product.

How Activity-Based Costing (ABC) Works

Activity-based costing (ABC) is for the most part utilized in the manufacturing industry since it upgrades the dependability of cost data, subsequently delivering almost true costs and better characterizing the costs incurred by the company during its production cycle.

This costing system is utilized in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is utilized to get a better handle on costs, permitting companies to form a more suitable pricing strategy.

The formula for activity-based costing is the cost pool total partitioned by cost driver, which yields the cost driver rate. The cost driver rate is utilized in activity-based costing to compute the amount of overhead and indirect costs connected with a specific activity.

The ABC calculation is as per the following:

1. Distinguish every one of the activities required to make the product.
2. Partition the activities into cost pools, which incorporates every one of the individual costs connected with an activity — like manufacturing. Compute the total overhead of each cost pool.
3. Assign each cost pool activity cost drivers, like hours or units.
4. Ascertain the cost driver rate by isolating the total overhead in each cost pool by the total cost drivers.
5. Partition the total overhead of each cost pool by the total cost drivers to get the cost driver rate.
6. Increase the cost driver rate by the number of cost drivers.

As an activity-based costing model, consider Company ABC that has a $50,000 each year electricity bill. The number of labor hours straightforwardly affects the electric bill. For the year, there were 2,500 labor hours worked, which in this model is the cost driver. Computing the cost driver rate is finished by partitioning the $50,000 per year electric bill by the 2,500 hours, yielding a cost driver rate of $20. For Product XYZ, the company involves electricity for 10 hours. The overhead costs for the product are $200, or $20 times 10.

Activity-based costing benefits the costing system by growing the number of cost pools that can be utilized to examine overhead costs and by making indirect costs recognizable to certain activities.

Requirements for Activity-Based Costing (ABC)

The ABC system of cost accounting is based on activities, which are any events, units of work, or tasks with a specific goal, like setting up machines for production, planning products, distributing completed goods, or operating machines. Activities consume overhead resources and are viewed as cost objects.

Under the ABC system, an activity can likewise be considered as any transaction or event that is a cost driver. A cost driver, otherwise called an activity driver, is utilized to allude to an allocation base. Instances of cost drivers incorporate machine arrangements, maintenance demands, consumed power, purchase orders, quality reviews, or production orders.

There are two categories of activity measures: transaction drivers, which includes counting how frequently an activity happens, and duration drivers, which measure how long an activity requires to complete.

Not at all like traditional cost measurement systems that rely upon volume count, like machine hours as well as direct labor hours to dispense indirect or overhead costs to products, the ABC system groups five broad levels of activity that are, partially, unrelated to the number of units that are created. These levels incorporate batch-level activity, unit-level activity, customer-level activity, association supporting activity, and product-level activity.

Benefits of Activity-Based Costing (ABC)

Activity-based costing (ABC) upgrades the costing system in three ways. To start with, it grows the number of cost pools that can be utilized to gather overhead costs. Rather than accumulating all costs in a single vast pool, it pools costs by activity.

Second, it makes new bases for assigning overhead costs to things to such an extent that costs are allocated based on the activities that generate costs rather than on volume measures, for example, machine hours or direct labor costs.

At last, ABC modifies the idea of several indirect costs, making costs recently thought to be indirect —, for example, depreciation, utilities, or salaries — recognizable to certain activities. On the other hand, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

Features

• An activity is a [cost driver](/activity-cost-driver, for example, purchase orders or machine arrangements.
• The ABC system of cost accounting is based on activities, which are viewed as any event, unit of work, or task with a specific goal.
• The cost driver rate, which is the cost pool total partitioned by cost driver, is utilized to work out the amount of overhead and indirect costs connected with a specific activity.
• Activity-based costing (ABC) is a method of assigning overhead and indirect costs — like salaries and utilities — to products and services.
  ABC is utilized to get a better handle on costs, permitting companies to form a more fitting pricing strategy.