Activity Based Costing
ABC Costing
Activity-based costing (ABC) is a cost accounting method that aims to assign overhead and indirect costs to the products or services being offered by an organization based on the activities required to produce them.
Traditional cost accounting methods typically rely on allocating indirect costs based on a single cost driver, such as direct labor hours or machine hours. However, this method can often lead to inaccurate cost allocations as indirect costs are not necessarily proportional to direct labor hours or machine usage.
ABC, on the other hand, identifies the specific activities required to produce a product or service and assigns the costs of those activities to the product or service. The costs of each activity are then allocated to the product or service based on how much of that activity is required to produce it.
For example, let's say a company produces two different products: Product A and Product B. Product A requires more machine setup time and more testing than Product B. In a traditional cost accounting system, both products would be assigned the same amount of overhead cost per machine hour. However, using ABC, the overhead cost per machine hour would be higher for Product A, as it requires more setup time and testing.
ABC typically involves the following steps:
1. Identifying activities: The first step in ABC is identifying the activities required to produce a product or service. This can include activities such as machine setup, testing, inspection, and quality control.
2. Assigning costs to activities: Once the activities have been identified, the next step is to assign the costs associated with each activity. This can include direct costs such as labor and materials, as well as indirect costs such as overhead.
3. Calculating activity cost drivers: The next step is to calculate the cost drivers for each activity. This is typically done by identifying the factor that drives the cost of each activity. For example, the cost driver for machine setup time may be the number of setups required.
4. Allocating costs to products or services: Once the activity cost drivers have been identified, the costs of each activity are allocated to the products or services based on how much of that activity is required to produce them.
ABC provides more accurate cost information than traditional cost accounting methods, allowing organizations to make more informed decisions about pricing, product mix, and process improvement. However, implementing an ABC system can be complex and time-consuming, as it requires a detailed understanding of the activities required to produce each product or service.
