Activity Based Costing (Copy)

4.1.1: Activity Based Costing (ABC) – Cheat Sheet

What is Activity Based Costing (ABC)?

• ABC is a costing method that allocates overheads to products based on activities that drive costs, rather than using traditional methods like direct labour hours or machine hours.
• The aim is to provide a more accurate method of assigning costs to products by focusing on the activities that cause costs, also known as cost drivers.

Key Concepts of ABC

1. Cost Drivers:
   • Cost drivers are the activities that cause the incurrence of overhead costs. These activities are responsible for the consumption of resources and contribute to the overall cost.
   • Examples of cost drivers include:
     • Machine hours
     • Number of purchase orders
     • Set-up time
     • Inspection hours
     • Direct labour hours
2. Activities in ABC:
   • ABC assigns overhead costs based on the number of activities performed, such as production setup, materials handling, quality inspections, etc.
   • The goal is to identify the activities that drive costs and allocate them more precisely than traditional costing methods.

Steps to Apply Activity Based Costing (ABC)

1. Identify Cost Drivers:
   • Identify and list all the activities that cause costs. Each activity will have a cost driver that links it to the resources consumed.
2. Assign Costs to Activities:
   • Calculate the total cost of each activity. This could include salaries, materials, equipment costs, etc.
   • The total costs for each activity are then accumulated into activity cost pools.
3. Allocate Costs to Products:
   • Allocate the costs of activities to the products based on how much of each cost driver is used by each product. For example:
     • If Product A requires 100 hours of inspection time and Product B requires 50 hours, the total inspection costs will be allocated proportionally.
4. Calculate Total Cost:
   • The total product cost is the sum of all direct costs (like materials and labour) plus the allocated overhead costs based on the cost drivers.
5. Determine Selling Price:
   • Once the total cost of the product is calculated, you can determine the selling price by applying a markup based on the desired profit margin.

Formulae in Activity Based Costing (ABC)

1. Cost per Unit of Activity:
   • Cost per Unit of Activity = Total Activity Costs / Total Activity Driver Units
2. Overhead Rate (Cost Driver Rate):
   • Overhead Rate = Total Activity Costs / Total Cost Driver Volume
3. Total Overhead Allocation:
   • Total Overhead Allocation = Activity Driver Rate × Number of Units of Cost Driver per Product

Advantages of Activity Based Costing (ABC)

1. More Accurate Costing:
   • ABC provides a more precise allocation of overheads because it assigns costs based on the activities that actually cause them.
2. Better Decision Making:
   • ABC helps managers make more informed decisions by providing insights into cost structures and the profitability of different products.
3. Identifies Inefficiencies:
   • By examining activities and their associated costs, ABC can highlight inefficiencies and areas where costs can be reduced or optimized.
4. Improved Pricing:
   • With a better understanding of the true cost of products, businesses can set more accurate and competitive pricing.
5. Useful for Complex Products:
   • ABC is particularly effective for businesses that produce a range of complex products with varying levels of resource consumption.

Limitations of Activity Based Costing (ABC)

1. Costly to Implement:
   • ABC can be expensive and time-consuming to implement because it requires detailed analysis of every activity and cost driver.
2. Complexity:
   • The process of identifying cost drivers and allocating costs can be complex and difficult to maintain, especially in large organizations with many different products and activities.
3. Requires Significant Data:
   • ABC requires extensive data collection about every activity, which can be a challenge, especially in businesses with diverse or rapidly changing operations.
4. Not Always Necessary for Small Businesses:
   • For small businesses with relatively simple operations, traditional costing methods may be sufficient and less costly.

Overhead Absorption Methods

1. Absorption Costing:
   • Under traditional costing, overhead is absorbed based on a single cost driver (e.g., labour hours or machine hours). This may not always reflect the actual activities causing the costs.
2. ABC vs Absorption Costing:
   • ABC allows for a more precise allocation of overheads based on activity drivers. Traditional absorption costing, by contrast, often uses a single driver and may over-simplify the allocation of overheads.

Using ABC to Make Business Decisions

• Pricing: ABC helps in setting the price of products by providing a more accurate calculation of their costs.
• Product Profitability: ABC can identify which products are profitable and which are not, allowing managers to make strategic decisions on which products to focus on.
• Cost Reduction: ABC highlights high-cost activities that do not add value, enabling managers to optimize and reduce costs.
• Cost Control: ABC helps in controlling costs by breaking down the cost structure and identifying areas of inefficiency or waste.

Conclusion

• Activity Based Costing (ABC) provides businesses with a more accurate method of allocating overhead costs based on activities and cost drivers.
• While it has advantages in providing more precise cost information, it is also complex and may be expensive to implement.
• ABC is especially useful in complex businesses with diverse products, but may not be necessary for simpler businesses where traditional costing methods suffice