HomeBlogProject ManagementActivity-Based Costing (ABC): Complete Guide
An accurate calculation and pricing of goods, products, and services are one of the challenging tasks to tackle for business owners and manufacturers. It only requires an “Exact Right Price” of goods and services. This is what attracts any customers automatically because of realistic transparency and because of worthy pricing. It makes a rise in the margin graph and gives a good profit.
But let me tell you, this is not as easy as making a cup of tea, it takes dealers to consider all the account factors where you are standing in the market, have knowledge of what competitors are doing, and make a profit without discouraging the customers.
With Activity Based Costing, products and service businesses can get into the core details to allocate the expenses in a better way. That means you can more precisely examine your expenditure and the price of your products. Now, let me help you develop a better understanding of the activity-based costing, with the help of this article:
Activity-Based costing (also known as ABC costing) defines as a costing technology that identifies the activities of an organization and allocates the cost of individual products and services based on the actual usage of each product. Therefore, this method gives an idea of indirect cost into direct cost compared to conventional costing.
Manufacturing and mass-producing businesses with overhead costs use Activity-Based costing to have a clear understanding of where investment is going. Activity-Based costing objectives give a detailed breakdown of the cost, where you can make a list of the actually profitable products.
By using Activity-Based costing:
The process of the ABC system involves the use of the following terminologies:
Now, let’s dive deep into Activity-based costing process on how it works internally. Here are step-by-step instructions which give an in-depth idea of the Activity Based Costing process:
The list of differences between Activity Based Costing vs Traditional costing is given below:
| Boundary of Comparison | Activity Based Costing | Traditional costing |
|---|---|---|
| Definition | ABC is majorly used for finding the indirect costs. | Traditional costing is for finding the cost for the products in advance. |
| Primary focus | ABC uses multiple cost drivers for multiple activities. | It used identical cost drivers for different activities. |
| Scope | ABC covers only product costing | Traditional costing covers both products as well as period costs. |
| Usage | Can be used in external financial statements. | Traditional costing cannot be used in reports of external costing. |
| Pricing strategy | It is a less expensive costing method. | It is expensive. |
| Types of activity performed | It can be utilized at the Unit level, Facility level. | Traditional costing can be utilized at Unit Level, Facility level, product level and batch level. |
Concluding the differences between Traditional based costing and Activity-based costing, traditional costing is a conventional method of costing, and it is an easy-going method for management. Also, the usage of Traditional costing is suitable for all types of companies that have a low set of costs.
ABC calculations can be given below:
Activity Based costing (ABC) is a method to determine the total cost of manufacturing a product, including overhead. It is calculated by taking the total cost pool and dividing it by the cost driver. Identifying product pricing can have a significant impact on a business and allows it to increase its revenue and profit margin when done correctly.
The formula for Activity based costing is as follows:
ACTIVITY BASED COSTING = COST POOL TOTAL / COST DRIVER
Cost Pool:
This is a product or an item to which the measurement of the cost would require.
Cost Driver:
It is a component that will add a change in the cost of the activity. There are two kinds of cost drivers:
Using the above given ABC formula: Cost Pool total / Cost Driver, the calculation of Machine setup cost is equal to:
Activity based costing example: The following details pertain to different activities and their costs for Gamma Ltd. You are required to calculate the overhead rate for each activity.
In the above example, it is given five activities, we must allocate the cost based on the cost drivers.
Formula - Cost Pool total / Cost driver
Each activity pools total cost into its cost driver to get distinct rates.
Overhead rate of activity = 1,20,000 / 200
Activity based costing purchase is equal to
Now the overhead rate of Purchased activity will be = 600.00
Similarly, find out the ABC cost formula for all activities.
Now the total estimated Overhead = 862500.00
The impact of practical capacity
Concerning the management customer service department, the survey of ABC work can be distributed about 70%, 20% and 10% of the time where employees spend time on the three activities. But this time can reflect how each employee utilizes and spends it in a productive way. But in the real scenario, the productive time spent is less than the actual time of 32 hours per employee per week was discarded. The calculation of the employees' cost of time estimation will go inappropriately, so the ABC cost drivers give accurate data about the cost and the efficiency of the process.
For calculating the cost driver:
Cost driver rate = total cost of Finishing activity per day / Cost Driver Units
== 40 total cost / 8 hours a day = $5
In the business organization, higher-level administrations can update their ABC costing model which can reflect changes in the system. It helps to bring up new product services to the business and the estimation can be done directly to get the unit time needed for each recent activity, instead of hiring resources.
The administrative team can also produce their own set of rates for cost-driven activities. In that majorly there are two factors which affect these changes in rates.
In capturing the complexity, we were dependent on the assumption that all transactions are either same or there might be the same amount of time to process the data. But Time-driven ABC costing is not in demand for this type of simplification. To simplify, estimating the process and producing a more accurate cost model than the one which could be possible using traditional ABC techniques.
The time-driven approach to Activity Based Costing can simplify the complexities of business than that of the traditional ABC costing system, which might take each process variant as a distinct activity.
Example: Consider a case, the Hunter Corporation (not the original name), a large, multinational distributor of scientific services, whose 27 facilities process more than one million orders each month to distribute up to 300,000 different product SKUs to 25,000 customers.
Its old ABC model required the employees of its own sales department to estimate each month the percentage of their time that they spend on three activities:
With the time-driven approach, Hunter’s ABC team of analysts was able to combine the three activities into a single departmental process, called inside sales order entry and it took about:
So, it was replaced by a single-time equation:
Inside Sales, Order Entry Process Time = 5 + (3 × number of line items) + 15 [if new customer] + 10 [if expedited order]
And this was straightforward to implement and easy to understand and resolves by saving time.
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The Activity Based costing system requires the following:
To finalize the ABC systems are those of adoption, implementation, and operation of the system is not end. The benefits could be translating the system designs and operations into action-oriented performance. Finally, it amounts to effective cost management for the success of the system.
There are several important benefits associated with activity-based costing. It gives a more accurate overview of products or services of costing.
To conclude, Activity-Based costing as it is a way of analyzing the organization’s costs to optimize the profit margins. If ABC costing is implemented with the correct understanding of the purpose, it can return great long-term value to the organization.
The ABC costing system gives a more accurate and cleaner picture of the production process and the costs associated with each area of production. This allows us to analyze the process and determine the areas that are functioning appropriately and which other areas might need improvement. Activity based costing with project management and its complete guidance can be found in the KnowledgeHut training for Project Management.
ABC's costings focus will always be on cost drivers, it includes the activities which cause an increase in costs. Based on the type of cost, it might divert focus on volume-related drivers. The main agenda of activity-based costing is to refine the indirect costs related to products, departments, processes.
Based on the expenses of a company, the levels of ABC are categorized into four distinct levels
The main advantage of activity-based costing is that it provides a more accurate method in services or products' costs, which also leads to giving more precise and accurate pricing decisions. The in detail on disadvantages of activity-based costing are explained above under Activity Based Costing (ABC) advantages and disadvantages.
ABC is a methodology that is used to determine the total cost of manufacturing a product. It is calculated by considering two factors total cost pool and the cost driver. I.e.
Cost pool total / Cost driver = Activity-based costing.
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