What is 'Activity-Based Costing - ABC'

Activity-based costing (ABC) is an accounting method that identifies the activities that a firm performs
and then assigns indirect costs to products. An activity-based costing (ABC) system recognizes the
relationship between costs, activities and products, and through this relationship, it assigns indirect
costs to products less arbitrarily than traditional methods.

Some costs are difficult to assign through this method of cost accounting. Indirect costs, such as
management and office staff salaries are sometimes difficult to assign to a particular product produced.
For this reason, this method has found its niche in the manufacturing sector.

BREAKING DOWN 'Activity-Based Costing - ABC'

Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability
of cost data, hence producing nearly-true costs and better classifying the costs incurred by the company
during its production process.

This costing system is used in target costing, product costing, product line profitability analysis,
customer profitability analysis and service pricing. It is also hugely popular since organizations can
develop a much better corporate focus and strategy if costs are better grasped.

Definition of Activities in ABC System

The ABC system of cost accounting is based on activities, which is any event, unit of work or task with a
specific goal such as setting up machines for production, designing products, distributing finished
goods or operating machines. Activities consume overhead resources and are considered cost objects.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost
driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of
cost drivers include machine setups, maintenance requests, power consumed, purchase orders, quality
inspections or production orders.

There are two categories of activity measures: transaction drivers, which involves counting how many
times an activity occurs, and duration drivers, which measure how long an activity takes to complete.

Unlike traditional cost measurement systems that depend on volume count such as machine hours
and/or direct labor hours to allocate indirect or overhead costs to products, the ABC system classifies
five broad levels of activity that are to a certain extent unrelated to how many units are produced.
These levels include batch-level activity, unit-level activity, customer-level activity, organization-
sustaining activity and product-level activity.

How ABC System Improves Costing Process

Activity-based costing enhances the costing process in three ways. First, it expands the number of cost
pools that can be used to assemble overhead costs. Instead of accumulating all costs in one
companywide pool, it pools costs by activity. It also creates new bases for assigning overhead costs to
items such that costs are allocated on the basis of the activities that generate costs instead of on volume
measures such as machine hours or direct labor costs. Finally, ABC system alters the nature of several
indirect costs, making costs previously considered indirect such as depreciation, inspection or power are
traced to certain activities.

However, ABC transfers overhead costs from high-volume products to low-volume products, raising the
unit cost of low-volume products.

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Introduction to Activity Based Costing

Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner
than the traditional approach of simply allocating costs on the basis of machine hours. Activity based
costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost
of those activities only to the products that are actually demanding the activities.

Let's discuss activity based costing by looking at two products manufactured by the same company.
Product 124 is a low volume item which requires certain activities such as special engineering, additional
testing, and many machine setups because it is ordered in small quantities. A similar product, Product
366, is a high volume productrunning continuouslyand requires little attention and no special
activities. If this company used traditional costing, it might allocate or "spread" all of its overhead to
products based on the number of machine hours. This will result in little overhead cost allocated to
Product 124, because it did not have many machine hours. However, it did demand lots of engineering,
testing, and setup activities. In contrast, Product 366 will be allocated an enormous amount of overhead
(due to all those machine hours), but it demanded little overhead activity. The result will be a
miscalculation of each product's true cost of manufacturing overhead. Activity based costing will
overcome this shortcoming by assigning overhead on more than the one activity, running the machine.

Activity based costing recognizes that the special engineering, special testing, machine setups, and
others are activities that cause coststhey cause the company to consume resources. Under ABC, the
company will calculate the cost of the resources used in each of these activities. Next, the cost of each
of these activities will be assigned only to the products that demanded the activities. In our example,
Product 124 will be assigned some of the company's costs of special engineering, special testing, and
machine setup. Other products that use any of these activities will also be assigned some of their costs.
Product 366 will not be assigned any cost of special engineering or special testing, and it will be assigned
only a small amount of machine setup.

Activity based costing has grown in importance in recent decades because (1) manufacturing overhead
costs have increased significantly, (2) the manufacturing overhead costs no longer correlate with the
productive machine hours or direct labor hours, (3) the diversity of products and the diversity in
customers' demands have grown, and (4) some products are produced in large batches, while others are
produced in small batches.

Activity Based Costing with Two Activities

Let's illustrate the concept of activity based costing by looking at two common manufacturing activities:
(1) the setting up of a production machine for running batches of products, and (2) the actual
production of the units of product.

We will assume that a company has annual manufacturing overhead costs of $2,000,000of which
$200,000 is directly involved in setting up the production machines. During the year the company
expects to perform 400 machine setups. Let's also assume that the batch sizes vary considerably, but the
setup efforts for each machine are similar.

The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per year).
Under activity based costing, $200,000 of the overhead will be viewed as a batch-level cost. This means
that $200,000 will first be allocated to batches of products to be manufactured (referred to as a Stage 1
allocation), and then be assigned to the units of product in each batch (referred to as Stage 2 allocation).
For example, if Batch X consists of 5,000 units of product, the setup cost per unit is $0.10 ($500 divided
by 5,000 units). If Batch Y is 50,000 units, the cost per unit for setup will be $0.01 ($500 divided by
50,000 units). For simplicity, let's assume that the remaining $1,800,000 of manufacturing overhead is
caused by the production activities that correlate with the company's 100,000 machine hours.

For our simple two-activity example, let's see how the rates for allocating the manufacturing overhead
would look with activity based costing and without activity based costing:

Next, let's see what impact these different allocation techniques and overhead rates would have on the
per unit cost of a specific unit of output. Assume that a company manufactures a batch of 5,000 units
and it produces 50 units per machine hour, here is how the cost assigned to the units with activity based
costing and without activity based costing compares:

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here is how
the cost assigned to the units with ABC and without ABC compares:
As the tables above illustrate, with activity based costing the cost per unit decreases from $0.46 to $0.37
because the cost of the setup activity is spread over 50,000 units instead of 5,000 units. Without ABC,
the cost per unit is $0.40 regardless of the number of units in each batch. If companies base their selling
prices on costs, a company not using an ABC approach might lose the large batch work to a competitor
who bids a lower price based on the lower, more accurate overhead cost of $0.37. It's also possible that
a company not using ABC may find itself being the low bidder for manufacturing small batches of
product, since its $0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units. With its bid
price based on manufacturing overhead of $0.40but a true cost of $0.46the company may end up
doing lots of production for little or no profit.

Our example with just two activities (production and setup) illustrates how the cost per unit using the
activity based costing method is more accurate in reflecting the actual efforts associated with
production. As companies began measuring the costs of activities (instead of focusing on the
accountant's departmental classifications), they began using ABC cost information to practice activity
based management. For example, with the cost of setting up a machine now being measured and
discussed, managers began to ask questions such as:

Activity Based Costing with Four Activities

Let's add two more activities to our example: procurement and material handling. The costs of these
two activities are not caused bynor do they correlate withmachine hours. Rather, we will assume
that both of these activities are related to the physical weight of the direct material used in making the
product.

The company determines that $300,000 of its annual manufacturing overhead is associated with
procurement and material handling. As a result, the company removes $300,000 from the
manufacturing overhead that will be allocated via machine hours, and instead plans to allocate the
$300,000 to the products based on the weight of the materials used. The company expects that during
the year it will procure and handle 3,000,000 pounds of material. Under activity based costing, the
company will assign $0.10 ($300,000 divided by 3,000,000 pounds) per pound of product weight to each
unit manufactured. The end result is that the heavier parts will not only have more direct material cost,
they will also be assigned more factory overhead than the lighter parts. By assigning some
manufacturing overhead to a product based on the product's weight, the remaining manufacturing
overhead assigned via machine hours will be reduced. These points are illustrated in the following table:

In the table below we can see how ABC would assign costs to the following:

A product that weighs 0.5 pound and is produced in a batch of 50,000 units at a rate of 50 per hour.

A product that weighs 1.5 pounds and is produced in a batch of 50,000 units at a rate of 50 per hour.

No activity based costing allocationsall manufacturing overhead costs are allocated entirely via
machine hours.
If the manufacturing overhead costs are caused by a number of activities such as setup, procurement,
handling, and production, then using the activity based costing method of determining costs will give
you a result that is closer to the true costs. As you can see, the product that weighs 0.5 pound is
assigned $0.36 of manufacturing overhead, while the product weighing 1.5 pounds is assigned $0.46 of
manufacturing overhead. Under the traditional costing allocations the procurement and handling costs
would be assigned on production hours. Keep in mind that whenever manufacturers have a diverse
lineup of products, allocating costs on a single basis (such as machine hours) will result in inaccurate per-
unit manufacturing overhead costs.

What is Activity based costing?

Activity based costing (ABC) is an accounting methodology that assigns costs to activities rather than
products or services. This enables resource and overhead costs to be more accurately assigned to the
products and the services that utilize the resources.

This example of a door company helps to explain the difference between the traditional method of
accounting and the activity based costing method. On the left column you have the traditional
accounting and on the right you have the ABC system that divides costs into activities.

Traditional method Activity based costing method

Salaries $100 Clean door $40

Equipment $80 Paint door $75

Supplies $20 Inspect door $75

Overhead $45 Send door to assembly $55

TOTAL: $245 TOTAL: $245

ABC doesnt eliminate or change costs, it provides data about how costs are actually utilized. In this
example, if you wanted to reduce costs using traditional data you would have to decrease salaries, or
decrease costs of supplies. You dont know enough to change the equipment or overhead costs. Using
ABC data you can see that it costs the same to paint and inspect the door. Could these steps be
combined to lower cost?

What are the benefits of ABC?

Traditional accounting systems are inaccurate in the method that they allocate costs. Large batch or
high volume products and services typically incur LESS OVERHEAD than they are assigned. Small batch or
low volume products and services typically incur MORE OVERHEAD than they are assigned. This
suggestss that products and services that are considered highly profitable may in fact be loss centers.
This inaccuracy is becoming more and more critical as companies move toward customer-defined
products and services. In order to correctly associate costs with products and services, ABC assigns cost
to activities based on their use of resources. It then assigns cost to cost objects, such as products or
customers, based on their use of activities. This information assists in making decisions about pricing,
outsourcing, capital expenditures and operational efficiency.

It is possible to draw the relationship between products/services (cost objects) and the resources that
are utilized by the product or service.

Resources

Resource drivers

Activities

Activities drivers

Cost objects

Definitions

Resources are people and machines.

The resource driver is the measure of the frequency and intensity of the demands placed on resources
by an activity
Cost pools is an accounting term that refers to groups of accounts serving to express the cost of goods
and service allocatable within a business or manufacturing organization.

Activities are the processes performed by people and machines.

Activity drivers measure the frequency and intensity of the demands placed on activities by cost
objects enabling costs to be assigned to cost objects.

Cost objects are the products and services produced.

Cost drivers are the factors that affect the cost of an activity, such as setup machines, quality control.

Advantages, Disadvantages and Limitations of Activity Based Costing (ABC) System:

Advantages of Activity Based Costing System:

Activity based costing system has the following main advantages / benefits:

More accurate costing of products/services, customers, SKUs, distribution channel.

Better understanding overhead.

Easier to understand for everyone.

Utilizes unit cost rather than just total cost.

Integrates well with Six Sigma and other continuous improvement programs.

Makes visible waste and non-value added activities.

Supports performance management and scorecards.

Enables costing of processes, supply chains, and value streams

Activity Based Costing mirrors way work is done

Facilitates benchmarking
Disadvantages or Limitations of Activity Based Costing System:

Activity based costing system help managers manage overhead and understand profitability of
products and customers and therefore is a powerful tool for decision making. However activity based
costing has a number of limitations or disadvantages.

These limitations or disadvantages are briefly discussed below:

Implementing an ABC system is a major project that requires substantial resources. Once
implemented an activity based costing system is costly to maintain. Data concerning numerous
activity measures must be collected , checked and entered into the system.

ABC produces numbers such as product margins, that are odds with the numbers produced by
traditional costing systems. But managers are accustomed to using traditional costing systems to run
theirs operations and traditional costing systems are often used in performance evaluation.

Activity based costing data can be easily misinterpreted and must be used with care when used in
making decisions. Costs assigned to products, customers and other cost objects are only potentially
relevant. Before making any significant decision using activity based costing data, managers must
identify which costs are really relevant for the decisions at hand.

Reports generated by this systems do not conform to generally accepted accounting principles (GAAP).
Consequently, an organization involved in activity based costing should have two cost systems - one for
internal use and one for preparing external reports.