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

activity based costing

In traditional costing it is assumed that if a customer generates positive contribution, then servicing that customer must increase the profits of the company. This ignores the fact that many ‘fixed’ overhead costs are customer specific – such as the time spent by customer service departments. 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 (referred to as a Stage 1 allocation), and then be assigned to the units of product in each batch (referred to as Stage 2 allocation). For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units).

activity based costing

The management knew that this movement of finished goods to and from Elmore Street was inefficient. However, since the company used a traditional cost accounting system, the only visible cost relating to this was the cost of transport – this was $200,000 per year. A solution to redesign the storage process in the South Street factory for the fast moving goods, and to move the slow moving inventory to Elmore Street (or destroy it entirely) was estimated to cost $600,000. It did not seem worth investing in this, given that the annual saving would be only $200,000.

Benefits of Activity-Based Costing (ABC)

The company had run out of storage space in their main factory in South Street, due to a large amount of slow moving inventory for their biggest customer, IBM. So additional storage space was rented in Elmore Street, several kilometres away from South Street. After production, the manuals for all other customers were transported to Elmore Street for storage.

  • It then assigns the cost of those activities only to the products that are actually demanding the activities.
  • For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 divided by 5,000 units).
  • Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.
  • The pre-sale work is essential for the organisation and the department converts 46% (16,000/35,000) of enquiries to orders.
  • It’s also possible that a company not using ABC may find itself being the low bidder for manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units.
  • In ABM however, it is recognised that the cost of a particular activity may depend on something other than volume of output.

If you install a generic ABC system and then use it for the above decisions, you may find that it does not provide the information that you need. Ultimately, the design of the system is determined by a cost-benefit analysis of which decisions you want it to assist with, and whether the cost of the system is worth the benefit of the resulting information. The state of the art approach with authentication and authorization in IETF standard RADIUS gives an easy solution for accounting all workposition based activities.

Transition to automated activity-based costing accounting

Under ABC, the company will calculate the cost of the resources used in each of these activities. Next, the cost of each of these activities will be assigned only to the products that demanded the activities. In our example, Product 124 will be assigned some of the company’s costs of special engineering, special testing, and machine setup. Other products that use any of these activities will also be assigned some of their costs.

activity based costing

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. An ABC system may require data input from multiple departments, and each of those departments may have greater priorities than the ABC system. Thus, the larger the number of departments involved in the system, the greater the risk that data inputs will fail over time.

Additional guidance and support

This gives management a full cost view of the results generated by each region, and therefore of the sources of the profits that the region is generating. The prerequisite for lesser cost in performing ABC is automating the data capture with an accounting extension that leads to the desired ABC model. Known approaches for event based accounting simply show the method for automation.

activity based costing

However, a separate OAR will be calculated for each activity, by taking the activity cost and dividing by the cost driver information. In addition to estimating more accurately the true cost of production, ABC will also give a better indication of where cost savings can be made. Remember, the title of this exam is Performance Management, implying that accountants should be proactive in improving performance rather than passively measuring costs. For example, it’s clear that a substantial part of the cost of producing Deluxe units is set-up costs (almost 25% of the Deluxe units’ total costs). Using the activity-based costing approach, we can determine overhead rates for each activity that is relevant to production. The activities listed below are given in this example but companies usually break down the relevant activities.

Determine Facility Production Costs

As the tables above illustrate, with How to Void Check for Direct Deposit the cost per unit decreases from $0.46 to $0.37 because the cost of the setup activity is spread over 50,000 units instead of 5,000 units. Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch. If companies base their selling prices on costs, a company not using an ABC approach might lose the large batch work to a competitor who bids a lower price based on the lower, more accurate overhead cost of $0.37. It’s also possible that a company not using ABC may find itself being the low bidder for manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units. With its bid price based on manufacturing overhead of $0.40—but a true cost of $0.46—the company may end up doing lots of production for little or no profit. Activity-based costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions.

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