Activity-based costing (ABC)

Activity-based costing (ABC) is an accounting method where costs are assigned to products (via overhead activities) in a more logical manner compared to the traditional approach where costs are usually allocated based on machine hours.

ABC traces overhead costs to the various activities within the business and then assigns those costs to objects. It’s a way to allocate indirect, overhead costs to products or departments that generate these costs in the production process.

The reason why ABC system is widely used is because it recognizes the relationship between costs, overhead activities, and manufactured products, and through this relationship, it assigns indirect costs to products less arbitrarily, when compared with the traditional methods.

While it offers several advantages, 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 product.

For this reason, Activity-based costing (ABC) has found its niche in the manufacturing sector. It is mostly used in the manufacturing industry where companies adopting this method have found that it enhances the reliability of cost data, produces nearly true costs, and better classifies 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.

Another reason why this accounting method is popular is because it enables organizations to develop a much better corporate focus and strategy as the various costs are better grasped & understood.

Here are some more differences between Activity-based costing (ABC) and Traditional costing methods (TCA)

• ABC provides accurate costs whereas TCA accumulates values arbitrarily.
• ABC methods help companies identify the need of keeping or eliminating certain activities to add value to the products.
• Traditional methods focus more on the structure rather than on processes whereas ABC methods focus on the activities or processes rather than on the structure.
• Traditional costing methods are almost obsolete now whereas ABC method is largely being used by various target-oriented companies.

ABC method provides a way to allocate costs more accurately, when overhead costs are not incurred at the same rate as direct labour cost. The more activities identified the more complex the costing system becomes that is why computer systems are needed for complex ABC systems. Some companies limit the number of activities used in the costing system to keep the system manageable. While this approach may result in some allocations being arbitrary, using ABC does provide a more accurate estimate of costs in the long run which can be used in making management decisions.

Important factors for selecting the cost drivers in ABC.

Usually, a cost driver is any activity that is the root cause of why a cost occurs. It must be applicable and relevant to the event that is incurring a cost. There could be multiple cost drivers responsible for the occurrence of a single expense. A cost driver helps in the allocation of expenses in a systematic manner, which results in more accurate calculations of the true costs of producing specific products.

Common Examples of cost drivers are: Direct labour hours worked, Number of customer contacts, Number of engineering change orders issued, Number of machine hours used, Number of product returns from customers

• The most common cost driver has historically been direct labour hours.
• In activity-based costing (ABC), an activity cost driver drives the costs of labour, maintenance, or other variable expenses.
• Expenses incurred relating to the layout or structure of a building or warehouse may utilize a cost driver of square footage to allocate expenses.
• More technical cost drivers include machine hours, the number of change orders, the number of customer contacts, the number of product returns, the machine setups required for production, or the number of inspections.

Cost drivers are characteristics of activities or events that cause a business to incur costs. By analyzing cost drivers, businesses can better understand the correlation between costs incurred and the activities that cause them. Furthermore, a cost driver provides the basis for cost allocation among business units that directly benefit from the cost incurred. A cost object may appear related to different activities, but while determining cost drivers, a business must choose those that correlate mainly with the cost object, and are the easiest for cost measurement. There are no industry standards or regulations stipulating mandating cost driver selection. A cost driver is selected at management’s discretion based on the associated variables relating to the expense being incurred. Cost drivers are essential in ABC, a branch of managerial accounting that allows managers to determine the costs to perform an activity at various activity levels.

MBA (management questions) on Activity-based costing (ABC):

Q) A company manufacturing two products furnishes the following data for a year.
Product, Annual Output Units, Machine hours, No. of purchase orders, No. of setups
A, 5,000, 12,500, 160, 20
B, 50,000, 1,25,000, 340, 50

The annual Overheads are as under:
Volume related activity cost (Activity driver-Machine hours) – 5,50,000
Setup related cost – 7,00,000
Purchase related cost – 6,20,000

You are required to calculate and compare cost per unit of each product based on Traditional method of charging overhead and Activity based costing method.

Q) Activity-based costing (ABC) has helped many companies for decades gain a true understanding of their costs to produce and distribute products to customers. ABC provides a precise, accurate view of costs at very granular levels—namely, at the individual product, service and customer level. Successes during the 1980s in applying ABC methods to manufacturing prompted an eventual expansion of this methodology to other key components of the supply chain (e.g., distribution). Manufacturers such as Proctor & Gamble and Warner-Lambert began using ABC models to determine their overall costs to serve individual customers (e.g., Walmart), and to evaluate the costs of offering different individual services to customers (e.g., services such as vendor-managed inventory and advanced shipment notices, or ASNs). (Source: Miller, B. T. The ABCs of Activity-Based Costing for Logistics.)

a. What is ABC and how is it different from the traditional costing methods?
b. Using suitable examples, explain the important factors for selecting the cost drivers in ABC.

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