Activity Based Costing (Copy)
Chapter 36: Activity-Based Costing (ABC)
Introduction to Activity-Based Costing
- Definition: Activity-Based Costing (ABC) is a costing method that allocates overhead costs based on the activities that drive those costs rather than using traditional volume-based allocation methods.
- Why ABC is Used:
- Traditional absorption costing often leads to inaccurate cost allocation.
- ABC provides a more realistic reflection of resource consumption.
- Helps businesses understand which activities consume the most overhead costs.
36.1 Key Concepts of Activity-Based Costing
- Cost Pools: Groups of overhead costs related to a particular activity.
- Cost Drivers: Factors that cause changes in the cost of an activity.
- Overhead Allocation: Costs are allocated based on cost drivers instead of a blanket rate for all products.
36.2 Steps to Implement ABC
- Identify Cost Pools:
- Group overhead costs into meaningful categories (e.g., machine setup, quality control, materials handling).
- Determine Cost Drivers:
- Identify factors that drive costs in each cost pool.
- Examples:
- Machine setup costs → Number of setups
- Ordering costs → Number of purchase orders
- Calculate the Activity Rate:
Activity Rate = Total Cost Pool / Total Activity Driver Volume - Allocate Costs to Products:
Overhead Allocated = Activity Rate × Activity Usage - Calculate the Total Cost per Unit:
Total Cost per Unit = Direct Costs + Allocated Overheads
36.3 Worked Example: ABC Calculation
- Company XYZ produces two products (A and B):
- Direct costs per unit:
Product A: $50, Product B: $40 - Overhead costs:
Machine setup: $100,000 Quality control: $50,000 Ordering costs: $30,000 - Cost drivers:
Number of setups: 200 (A: 80, B: 120) Quality inspections: 500 (A: 200, B: 300) Number of orders: 300 (A: 120, B: 180)
- Direct costs per unit:
Step 1: Calculate Activity Rates
Machine Setup Rate = 100,000 / 200 = $500 per setup
Quality Control Rate = 50,000 / 500 = $100 per inspection
Ordering Cost Rate = 30,000 / 300 = $100 per order
Step 2: Allocate Overhead Costs
Product A:
Setup Cost: 80 × 500 = $40,000
Quality Control: 200 × 100 = $20,000
Ordering Cost: 120 × 100 = $12,000
Total Overhead = $72,000
Product B:
Setup Cost: 120 × 500 = $60,000
Quality Control: 300 × 100 = $30,000
Ordering Cost: 180 × 100 = $18,000
Total Overhead = $108,000
Step 3: Calculate Total Cost per Unit
Product A: (Direct Cost: $50) + (Overhead: $72,000 / Units Produced: 1,000) = $122 per unit
Product B: (Direct Cost: $40) + (Overhead: $108,000 / Units Produced: 2,000) = $94 per unit
36.4 Advantages of ABC
- More Accurate Cost Allocation:
- Identifies actual resource consumption by each product.
- Better Decision Making:
- Helps managers in pricing, cost control, and profitability analysis.
- Identifies Cost Drivers:
- Helps businesses understand the reasons for high costs.
- Encourages Cost Reduction:
- Highlights inefficiencies and areas to cut costs.
36.5 Disadvantages of ABC
- Time-Consuming & Complex:
- Requires detailed data collection and analysis.
- High Implementation Costs:
- Needs software and trained personnel.
- Not Always Practical for Small Businesses:
- May not justify the cost of implementation.
36.6 Comparison: ABC vs. Absorption Costing
| Feature | ABC | Absorption Costing |
|---|---|---|
| Basis of Allocation | Cost Drivers | Labor/Machine Hours |
| Accuracy | High | Low |
| Complexity | High | Low |
| Decision Making | Better for pricing & cost control | Suitable for financial reporting |
36.7 Decision-Making Using ABC
- Setting Selling Prices:
- Ensures that all overheads are accounted for.
- Identifying Unprofitable Products:
- Helps determine which products should be discontinued.
- Improving Operational Efficiency:
- Identifies high-cost activities and reduces unnecessary expenditures.
36.8 Real-World Application of ABC
- Manufacturing:
- Automotive and electronics industries use ABC to track production costs.
- Retail & Services:
- ABC helps in customer profitability analysis.
- Healthcare:
- Used in hospitals to allocate costs to different treatments and procedures.
Conclusion
- Activity-Based Costing (ABC) provides a more accurate way of allocating overheads compared to traditional methods.
- It helps in better pricing, cost control, and decision-making but requires time and resources to implement effectively.