Aka. ABC. A costing method that assigns overhead costs to related products and services. Recognizes the relationship between indirect costs and overhead activities, assigning indirect costs to products less arbitrarily than traditional costing methods.
Activity
Aggregation of many different tasks, events, or units of work that cause the consumption of resources. Each activity forms its own cost centre, so ABC works with many more cost centres than traditional costing methods, which pool overhead into a small number of departmental cost centres.
Examples: machine setups, production scheduling, material handling, inspection, purchasing, dispatch.
Activity Cost Pool
The overhead cost attributed to a distinct type of activity.
Examples: setup cost pool, production scheduling cost pool, material handling cost pool, inspection cost pool, dispatch cost pool.
Cost Drivers
Any factor which causes a change in the cost of an activity.
Examples:
- Set up costs, driven by number of production runs.
- Production scheduling cost, driven by number of production runs.
- Material handling cost, driven by number of production runs.
- Inspection costs, driven by number of inspections.
- Raw material inventory handling cost, driven by number of purchase orders delivered.
- Dispatch costs, driven by number of customer orders delivered.
Steps
- Identify and classify the major activities, and allocate manufacturing overhead costs to the appropriate cost pools.
- Identify the cost driver with a strong correlation to the costs in the cost pool.
- Compute the overhead rate for each pool.
- Assign overhead costs to products using the overhead rates.
Benefits
- Easily identify the root causes of poor financial performance.
- Identify the most and least profitable products and channels.
- Accurately predict cost.
- Track costs of activities.
- Facilitate a better marketing mix.
- Enhance bargaining power with the customer.
Activity Based Management
An extension of ABC from a product costing system to a management function that focuses on reducing costs and improving processes and decision making.
Value-Added Activities
Activities that increase the value of the product or service to the customer, and which the customer would be willing to pay for. Removing one reduces the product’s value.
Examples: assembly, painting, packaging.
Non-Value-Added Activities
Activities that do not increase the value of the product or service to the customer. Can be eliminated without affecting the product’s value.
Examples: storage, inspection, material movement, waiting time.
Worked Example
Consider products and , with 2 cost pools.
| Cost Pool | Cost Driver | Pool Cost | Total Driver Volume | ||
|---|---|---|---|---|---|
| Set up costs | Production runs | ||||
| Inspection costs | Inspections |
The cost driver rate for each pool is the pool cost divided by the total driver volume.
Overhead assigned to each product is the sum of each cost driver rate multiplied by that product’s usage of the driver.
