Nis 22 2020

Activity-Based Costing Overview, Approach, Benefits

(e) It results in more accurate cost calculation of a product or job. You need a member of staff with the knowledge and time to collect and collate this amount of data. And to make it sustainable and repeatable, you need to implement an efficient system throughout your company. Many SMEs find that the cost of putting this in place outweighs the ROI of this accounting system. And that’s even FreshBooks clients that have all the cost information they need right there, a couple of clicks away.

For instance, pleasant work place may not be identified as an activity adding value according to operational activity based management. However, it helps in attracting and retaining the best staff which is a great benefit to the whole organization. Similarly, a customer may be identified as a low value customer because of loss from transactions with him according to strategic ABM. Managers can set cost reduction targets in terms of reducing the cost per unit in relation to cost allocation base in different activities areas.

  1. The activity based costing method is helpful in ascertaining areas where cost reductions are possible.
  2. In contrast, Activity based costing (ABC) systems focus on activities required to produce each product or provide each service based on each product’s or service’s consumption of the activities.
  3. Under Conventional or Traditional Costing System, overhead expenses are identified initially with the cost centres which comprise of both the production departments and service departments.
  4. (iii) Having identified activities and their costs, next step is to determine the basis (cost driver) for allocating activity-wise costs.
  5. This means you can finally say goodbye to broad, inaccurate cost allocations and hello to a more detailed and precise picture of your business’s expenses.

A cost pool consists of one or more similar activities that can’t be identified easily with specific products, services, departments etc. Cost pools are used to account for the common costs of the organization. Under the traditional absorption costing method, Product ‘R’ is more expensive while under activity-based costing method, product ‘P’ is more expensive.

Activity Based Costing – Evolution of ABC

The factors which influence the cost of a particular activity should identified, which are known as Cost Drivers. ABC is based on the assumption that cost behavior is influenced by cost drivers. It should be noted that directs costs do not need cost drivers as they can be identified directly to a product. Therefore cost drivers signify factors, forces or events that determine the costs of activities. Cost of activity will be charged to the product using cost driver rate according to the requirement of activities of each product. For instance, a product may require 10 machine setups and 1 inspection related activity.

It facilitates the preparation of an activity-based budget by providing the management with a clear view on the details of various activities. Hence, there is a need for more systematic and accurate system for cost ascertainment and cost control. The attempts to find a satisfactory answer to overcome the limitations of Traditional Costing resulted in the development of Activity-Based Costing. (f) Improved cost-basis available both at head office and plant level for better decision making.

Activity Based Costing – 5 Limitations of Activity Based Costing

As an activity-based costing example, consider Company ABC that has a $50,000 per year electricity bill. For the year, there were 2,500 labor hours worked, which in this example is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. To get more accurate figures for the product cost, activity-based costing – ABC system is followed to allocate the overhead cost fairly between different products. The use of the ABC costing system requires us to identify the activities used in the production process and allocate the total fixed overhead based on the usage of activities by individual products. The conventional overhead allocation method assumes that various types of the fixed overhead cost can be absorbed in different products using a single overhead absorption rate.

Difference Between Traditional Costing and Activity-Based Costing

First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. Activities consume overhead resources and are considered cost objects. The traditional system of costing allocates overhead cost based on a single Absorption rate.

The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity. In ABC, variable overhead is appropriately traced to individual products. The costs incurred as the units are produced have been traditionally treated as variable overhead. But when fixed overhead are apportioned on the basis of units made, as in traditional costing, such apportionment is likely to be arbitrary and also may not reflect activities and cost actually consumed by the products.

The cost driver for product design is the total hours spent on design. Let’s say the first unit-level activity is cutting fabric, and the total cost is $10,000. In this section, we’ll explore the advantages and disadvantages of the ABC method so you can decide if it’s the right costing method for your business. This abcosting means you can finally say goodbye to broad, inaccurate cost allocations and hello to a more detailed and precise picture of your business’s expenses. The state of the art approach with authentication and authorization in IETF standard RADIUS gives an easy solution for accounting all workposition based activities.

There are other types of cost accounting that may be more appropriate. 300 of these new machines are for your new product, and you want to factor this into working out the overall cost of production to predict if it will be profitable. If we apply the ABC process we can see that Step 1 is complete as we know what the cost pools are. This is derived from the budgeted outputs of 20,000 Ordinary units which each take five hours (100,000 hours) to produce, and 2,000 Deluxe units which each take six hours (12,000 hours).

Activity Based Management (ABM) aims to maximize the value adding activities while minimizing or eliminating non-value adding activities in an organization. Its overall objective is to improve efficiency and effectiveness of an organization in securing its markets. It depends heavily on Activities Based Costing (ABC) as a source of its information.

Should I Use Activity-Based Costing?

As some products are produced in large batches and some in small batches. Therefore it is one of the effective methods of exercising cost control and can be used in designing either job costing system or process costing system. The cost sheet may look like the following once all activity-related costs are measured.

These are just a few of the things that activity-based costing will clearly point out to you, allowing you to make the management decisions that can streamline operations and save money. Allocations, therefore, vary directly with the ‘volume of units produced, cost of merchandise sold or days occupied by the customer. Thus, it is believed that activity-based costing helps in presenting a more realistic picture of the behavior of costs. In today’s competitive business environment, accurately understanding your fixed and variable costs is crucial for success.


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