Activity-based costing (ABC) is a strategic tool that provides organisations with a clear understanding of costs and actual profitability of the ventures. When compared to conventional costing methods, it provides better essential information on how resources are used in production or in providing services.
By incorporating activity-based costing, organisations can be better placed to make more informed decisions and enhance organisational costs. A specialised Training Course in Project Scheduling, Budgeting & Cost Management from the British Academy for Training and Development highlights insights for effective scheduling, resource allocation and cost control.
Activity-based costing is a costing system that allocates costs to products and services in relation to the number of activities carried out in producing them.
Unlike traditional costing, which assigns overhead costs by using a single measure such as labour hours, ABC Costing employs numerous activity bases (cost drivers) to allocate costs.
For example, consider a manufacturing company producing two products: a simple standard widget and a custom widget. ABC Costing notes that the actual activity for the product custom widgets involves extra activities namely design and quality testing and therefore attracts more cost. In this method, the business ensures that these costs are correctly allocated, improving pricing factors and profitability.
The main distinctions between activity-based costing (ABC) and traditional costing systems are the methods of overhead costs allocation.
Traditional costing only employs a single overhead rate, such as labour or machine hours, to spread expenses evenly, which often leads to greater errors in costing. In contrast, ABC Costing allocates costs more frequently with the help of several cost drivers or activity bases including machine setups or inspections, which indicate real consumption of resources.
Compared to the traditional costing, ABC Costing offers better depth of analysis, which can be conveniently credited to the fact that it is slightly more complex and difficult to apply. It is also more effective in businesses that deal with numerous products or services, some of which require extensive resources to be allocated for their production.
Activity-based costing steps include:
Start by enumerating all the processes involved in the production of a product or in the delivery of a particular service, for instance setting up, inspecting or handling materials. These activities are the basis for the implementation of correct cost allocation. Dick’s activity list avails every resource touch point to mitigate dangers of abandoning consumption resources. An activity list guarantees that none of the resources is left out during the implementation of the project.
Classify all costs that can be associated with each of the identified activities into direct costs and indirect costs. For instance, label setup costs to machinery preparation or times spent on checking for defects as inspection costs. This step helps to avoid any unfair sorting of costs.
Determine the cost driver or activity bases and understand how it influences each activity, be it the number of machine hours, number of setups or customer orders. These bases support in determining the usage of the resources for each activity. One should select drivers that are most suitable for capturing the resource utilisation.
Determine the activity rate with the aid of the formula total cost of the activity divided by the activity base. This gives the cost per unit of activity for example the cost of machinery set up is £200. The activity rate therefore helps with accurate cost allocation.
Allocate costs to products or services according to the amount of each activity consumed by a product or service using the activity rates calculated. This step helps in allocation of resources in an equitable manner and also gives availability of the activities in production or services delivery.
Adopting ABC costing offers several advantages that can benefit businesses across industries:
Improved accuracy: It ensures a more accurate representation of resources because it involves allocation of the costs on the basis of activity bases.
Enhanced decision-making: Businesses are able to define unprofitable products or services and make appropriate decisions regarding pricing and production.
Cost control: When cost-intensive activities are highlighted, organisations can develop strategies to reduce expenses.
Better resource allocation: The right resources can be focused on high-value activities, thus enhancing organisational productivity.
Despite its benefits, ABC Costing is not without drawbacks:
Complexity: The process involves data collection and analysis, which takes a lot of time to accomplish.
High implementation costs: Implementation of an activity-based accounting system requires some certain capital investment.
Data dependence: Results accuracy depends on the quality and reliability of data that have been used.
Limited applicability: Traditional costing can be adequate for small business concerns or less complex production operations, hence making ABC Costing unnecessary.
In order to calculate the activity rate, one has to learn how the costs are allocated to particular activity and divided according to the usage. The activity-based costing formula is as follows:
Activity Rate = Total Cost Pool / Total Cost Drivers
Here’s how to break it down:
Cost Pool: A cost pool is a gathering of all the overhead costs associated with a particular activity, for example, machine setup or customer service. Begin by grouping costs that are in some way similar to these pools. For instance, if you are computing overhead costs for quality control, your cost pool would consist of inspection wages and costs of testing equipment.
Cost Drivers: A cost driver influences the variations in the cost of the activity. Typically cost drivers include machine hours, labour hours or even the number of orders produced. These drivers calculate activity level and are used to distribute costs.
Activity-based costing examples include:
A retail chain uses expenses by controlling purchase orders to suppliers, where costs vary with the number of issued orders to restock inventory.
An online bookstore manages customer invoices for any transaction that occurs within the store, and this comes with some cost associated with the volume of invoices that are required for a certain number of processed customer transactions
A tech support centre supports its clients, whereby cost is based on the number of customers that have been served in tackling technical problems or answering questions.
In conclusion,
Activity-based costing is a robust tool for organisations that are in search of improved and effective methods of managing costs. Due to its concentration on activity bases and cost drivers, this method is incredibly helpful in offering insights that help in decision making regarding improvements of profitability and resource utilisation. Although ABC Costing can be effort demanding in its implementation, the benefits that come with the strategy outweigh the challenges, hence a very important strategy for any business today.