🕑 Reading time: 1 minute
Activity-based costing or ABC is a costing approach for optimizing cost and time. Besides measuring the performance of an activity, this cost accounting technique helps to identify all the costs related to every unique activity. The activity can be placed anywhere within an organizational structure, comprising of a project or process.
In Activity-based costing, resource costs are assigned to activities that consume resources, and activity costs are assigned to the cost objects like services, products, and customers. ABC thus recognizes the relationship between the activities and cost drivers.
Need of Activity-Based Costing
The manufacturing industry has seen a 360-degree shift in its processes over the years. Technological innovation is at its peak, bringing in automation and many other advancements. This has also given rise to competition worldwide.
This shift has decreased the amount of direct labor required in the industry. The overhead costs are on the rise due to factors such as depreciation, maintenance, and repair works of the equipment, etc.
Since no correlation is seen between direct labor and overhead costs incurred, predetermined overhead rates based on direct labor are used, which is inappropriate. This would lead to a significant cost deviation.
Activity-based costing can help avoid this aberration. This method allocates overhead costs by adopting multiple bases. It helps to prevent extra costs.
Applications of Activity-Based Costing
- Activity-based costing can develop and refine the cost of a particular value stream.
- ABC serves as a decision-making tool for degerming the profitability of a product or service.
- Activity-based costing provides comparative standards to perform benchmarking and reengineering.
- A selective and focused approach towards the important activities can be adopted due to ABC.
Process for Activity-Based Costing
1. Identify Activities
For ABC, major activities involved have to be identified.
It can be divided into the following subcategories:
a. Unit-level or Primary Activities
The cost of the basic materials required is based on the volume of the output to be delivered.
b. Batch-level Activities
The manufacturing support activities such as ordering materials and its inspection constitute the batch level activities.
c. Product-Level Activities
Product level activities include keeping activities up to date, advertising of a product, etc.
d. Facility-level Activities
Facility-level activities include security, maintenance, salaries, etc.
2. Assign Costs to Activity Cost Pools
The total costs incurred for a group of activities is known as a cost pool. Costs must be assigned to the cost pools for a specified time period.
3. Identify Factors influencing the Cost of Activities
Identify the functional area cost drivers. The functional areas include materials management, quality control, R&D, marketing, etc.
Materials management consists of issuing purchase orders and inspection of materials. The number of purchase orders placed is the cost driver for these activities.
4. Assign the Cost of Activities to the Product
The demand for each activity is different. Assign the costs accordingly. The overhead costs come into the picture in this step.
Benefits of Activity-Based Costing
- ABC provides accurate information as compared to the traditional costing method. It puts forth a different perspective of the cost structure.
- Activity-based costing enhances control of overhead costs as overheads are not driven by the volume of work.
- This technique identifies the non-value-adding activities. Thus, reducing the cost.
- Managers can make better decisions.
Limitations of Activity-Based Costing
- There is a risk of spending too much time and effort over gathering and sorting the data.
- The level of complexity is high. The managers find it frustrating.
- Activity-based costing can be expensive.
Activity-based costing is a cost accounting technique that identifies all the costs related to every unique activity.
ABC is an accurate costing method which leads to better pricing decisions. This method eliminates excess overhead costs.
Adopting ABC leads to better control over the cost of each activity, and the non-value-adding activities are identified. This also helps with the decision-making processes of the project.
READ MORE: Cost Estimation of Construction Projects