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What’s it: Activity-based costing (ABC) is a costing approach in which the company will first identify the activities it undertakes and then determine the resources consumed by each activity. Under this method, the product’s cost is based on the actual resources consumed and the effort actually made.
The difference between activity-based costing and traditional costing
The activity-based costing method calculates product costs more accurately than traditional methods. The company takes into account all indirect costs and categorizes them based on the activities carried out.
Professors Johnson and Kaplan proposed this approach in their 1987 book entitled: “Relevance Lost: The Rise and Fall of Management Accounting.” Both questioned accounting techniques based on cost absorption.
They then propose a method that recognizes all costs for each activity within the company. They are of the view that the product must bear the costs according to the activities consumed.
For supporters, this method provides a more plausible reason. The company will know the reasons why certain costs arise. Long story short, this approach emphasizes the causal relationship of each cost.
You won’t find such an approach in a traditional costing system. Under the traditional approach, you add the average overhead rate to the direct costs of the product. The traditional approach emphasizes short-term financial performance, while activity-based costing focuses on cost, quality, and time factors.
The traditional approach is more suitable when the contribution of overhead costs to production costs is relatively small. And, it provides a reasonably accurate figure when it comes to large production volumes.
Benefits of activity-based costing
Activity-based costing assigns costs to products according to the resources actually consumed. This method identifies cost drivers such as machine setup, job scheduling, and material handling. The company then allocates these costs according to the level of activity that actually occurs.
All overhead costs are traced to individual products. Hence, activity-based costing forms an integral component in the strategic planning process. It provides a necessary source of information for future cost assumptions.
The following are the advantages of the activity-based costing method:
- Provide more comprehensive information about the activities undertaken by the company to produce products.
- Provides management with a tool for understanding how costs arise and how to manage them. This contrasts with historical cost analyzes, which often fail to reflect actual costs.
- Designed to control indirect costs and to reflect actual costs. With this method, management can identify areas of savings and cost reduction. They can track potential processes and activities for simplification, based on consideration of cost drivers.
Steps in activity-based costing and examples
A key aspect of the activity-based costing method is identifying and measuring cost drivers. Companies need to break down complex activities into specific activities.
The method can be applied to all types of activities, including, for example, the delivery of products to customers. Variables may include the time spent loading goods onto the vehicle, the distance between delivery points, the number of stops made, etc.
All those individual activities represent the accumulated costs for the entire process. Each activity can then be assessed in terms of cost.
The following are examples of the stages in applying the activity-based costing method:
Identifying the activities required to complete the product
An activity definition is any process or procedure that consumes overhead resources. Defining activities is essential to understand all the activities required to make a product.
Examples of activities that have an enormous impact on overhead are:
- purchase of materials
- machine setup
- machine operation
- product assembly
- finished product inspection
Assigning overhead costs for identified activities
The company assigns overhead costs to each activity and then breaks them down. For example, the cost pool for a materials purchasing activity would include purchasing personnel salaries, rent for purchasing departmental office space, and depreciating office equipment.
Assume that the total overhead cost for the purchase of materials is IDR180 million.
Identifying the cost drivers for each activity
Cost drivers are activities that generate costs. Companies gather information and interview key personnel in areas such as purchasing, production, quality control, and accounting to identify it.
For example, for the purchase of raw materials, the cost driver is the purchase request. Say, in one year, there are 90,000 requests for purchases of raw materials from suppliers.
Meanwhile, for finished product inspection activities, the driving force behind the cost is inspection hours. Say, for a year’s production, there would need to be as many as 30,000 inspection hours.
Calculating the overhead rates that have been determined for each activity
The firm then divides the estimated overhead costs by the estimated level of cost-driving activity.
For example, for the purchase of materials, the total purchase overhead would be IDR180 million for a purchase request of 90,000. From this data, the company calculates the overhead rate for material purchasing activities of IDR2,000 per purchase request (IDR180 million/90,000).
Allocating overhead costs for products
The company then allocates the overhead to the product. The firm multiplies the overhead rate by the cost driver used by each product.
For example, for product A, the cost driving activity for purchasing materials is 50,000 purchase requests. Meanwhile, for product B, there are as many as 40,000 purchase requests.
Therefore, the allocation of overhead costs for product A purchasing activities is 40,000 x IDR 2,000 = IDR80,000,000. Meanwhile, for product B, the overhead cost of purchasing materials is 50,000 x IDR2,000 = IDR100,000,000.
