Activity Based Costing Accounting Explained

activity based costing

By doing so, managers can see which activity drivers need to be reduced in order to shrink a corresponding amount of overhead cost. For example, if the cost of a single purchase order is $100, managers can focus on letting the production system automatically place purchase orders, or on using procurement cards as a way to avoid purchase orders. Either solution results in fewer purchase orders and therefore lower purchasing department costs. Use an activity driver to allocate the contents of each primary cost pool to cost objects. To allocate the costs, divide the total cost in each cost pool by the total amount of activity in the activity driver, to establish the cost per unit of activity.

It was within this context that https://www.bookstime.com/, or ABC first appeared. The ABC system is based on the analysis of specific costs related to every activity performed by a company in the manufacturing of its products or services. Based on these activities, resources are allocated to various products, services, markets, etc., generating a clear vision of the company’s costs. In this manner, the company has a more precise view of the impact of each activity on the operational costs of the business, facilitating more adept management of its profitability. Traditional costing applies an average overhead rate to direct production costs based on a cost driver (e.g., hours or volume). Over the past 15 years, activity-based costing has enabled managers to see that not all revenue is good revenue and not all customers are profitable customers. Unfortunately, the difficulties of implementing and maintaining traditional ABC systems have prevented them from being adopted on any significant scale.

Difference between Traditional Costing and ABC Approach

An activity is a cost driver, such as purchase orders or machine setups. In this section, I have provided step-by-step instructions on how to use activity-based costing, along with an in-depth example. R. J. Lewis, “Activity-based models for cost management systems,” Quorum Books, Westport, CT, 1995. Product‐line activities are those activities that support an entire product line but not necessarily each individual unit.

It is up to you how you want to conduct these interviews, but the main purpose of this is to identify how the money is spread throughout the activities. For instance, if you have an employee who works in customer service as well as order processing, you can ask them how much time he/she spends on each activity. Activity-based costing became popular in the early 1980s largely because of growing dissatisfaction with traditional ways of allocating costs. Even Robert Kaplan , a Harvard Business School professor sometimes credited with being its founding father, has admitted that it stagnated in the 1990s.

3 Using Activity-Based Costing to Allocate Overhead Costs

Quality programs, continuous improvement efforts, reengineering, or the introduction of new technology can enable the same activity to be done in less time or with fewer resources. When permanent, sustainable improvements in a process have been made, the ABC analyst recalculates the unit time estimates to reflect the process improvements. For example, if the customer service department gets a new database system, the reps may be able to perform a standard credit check in 20 minutes rather than 50 minutes.

activity based costing

It would be nothing but multiplying different overhead rates as arrived above with their actual cost drivers. The Chinese electricity company Xu Ji used ABC to capture direct costs and variable overheads, which were lacking in the state-owned enterprise’s traditional costing systems. The ABC experience has successfully induced standardisation in their working practices and processes. Standardisation was not a common notion in Chinese culture or in place in many Chinese companies. ABC also acts as a catalyst to Xu Ji’s IT developments – first accounting and office computerisation, then ERP implementation. ABC focuses attention on cost drivers, the activities that cause costs to increase. Traditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received.

The implementation of an Activity-Based Costing (ABC) system in a manufacturing company

Many companies were not prepared to give up their traditional cost-control mechanisms in favour of ABC. Cost data gathering involves the determination of the costs incurred by the activities being analyzed. These costs include salaries of the people performing the activities, material costs, equipment and furniture costs, and even R&D costs.

Again, that was probably a safe assumption to make in traditional manufacturing businesses that typically made a small range of products. So, actually, if we have overheads that behave in different ways, we need to understand that behaviour, so we can hopefully work out an accurate cost. However, once again, it’s the case that in a modern manufacturing environment, the production process is so complex, that we’ve got loads of overheads; but not all of them are fixed, certainly not over the medium to long term. The idea is that to actually offer a product or provide a service, there’s a chain of activities that will take place for that to happen, and ABC is going to break the business down into these different activities.

Top 8 Activity Based Costing Software

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. Divide the total overhead of each cost pool by the total cost drivers to get the cost driver rate.

  • Even in ABC, some overhead costs are difficult to assign to products and customers, such as the chief executive’s salary.
  • If production batches are of greatly varying lengths, then consider creating cost pools at the batch level, so that you can adequately assign costs based on batch size.
  • Under activity-based costing four cost pools are identified with each cost pool having an estimated $250,000 in overhead costs.
  • Time-driven ABC has overcome these difficulties, offering a transparent, scalable methodology that is easy to implement and update.
  • So, actually, if we have overheads that behave in different ways, we need to understand that behaviour, so we can hopefully work out an accurate cost.

ABC provides more accurate and informative product costs which in turn help the management to take decisions about pricing, product lines and market segments. Activity cost centres are, sometimes, similar to cost centres used under activity based costing traditional costing system. In case the purchase department and purchasing activity both are treated as cost centres, the support activity cost centre also becomes identical to cost centre taken under traditional costing system.

And again, we, therefore, have that situation where different products put very, very different demands on the business. Nowadays, it just simply isn’t the case that if something’s produced in a larger volume, it necessarily places bigger demands on the business in every single area of the production process. The CIMA definition goes on to say “…resources are assigned to activities and activities to cost objects”. In defining ABC, first of all, what we would say is it is a more complex system of cost accounting than absorption costing. ABC gives us a much more detailed look at the manufacturing part of a business if we’re talking about a manufacturing organisation.

Is machine hours an activity cost pool?

Explanation: An activity cost pool refers to all costs spent on performing a certain activity in a business, such as the production of a particular product. An activity cost pool includes all costs incurred in machining, setting up machines and inspecting but it does not include machine hours.