Activity-based costing, ABC, is 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.
Concepts
- Activities
Aggregation of many different tasks, events, or units of work that cause the consumption of resources. - Activity cost pool
The overhead cost attributed to a distinct type of activity. - 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.
Absorption Costing vs ABC
- Cost centres
Absorption uses a small number of cost centres. ABC uses a greater number of activity cost centres. - Cost drivers
Absorption uses a small number of cost drivers. ABC uses a greater number of cost drivers. - Allocation
Absorption allocates overhead to cost centres, then service department cost again to production. ABC assigns cost to major activities and applies cost drivers.
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.
- Non-value-added activities.