Introduction to Activity Based Costing Methods
Activity based costing (ABC) is a very direct way of assigning running costs or indirect costs for a business as a result of the operations (that is ‘activities) that are the reasons for the running costs. This is why this article is aimed at helping you to optimize your cost structure with activity based costing methods.
What is Activity Based Costing (ABC)?
Activity based costing (ABC) is one of the methods of costing that appoints running costs, or overhead costs to products and services that are connected. This cost could also include indirect costs that are involved in the entire process. Activity based costing method puts into consideration the association between all kinds of costs and activities. Activity based costing is adopted in order to get a firmer hold on cost. This allows organizations to develop a more suitable pricing strategy.Â
The activity based costing method is used in product costing, target costing, service pricing and product line profitability analysis. For example the total costs, indirect activities, and the products itself. One difference between activity based costing methods and other methods of costing is that activity based costing works by allocating indirect costs to the products that are less spontaneous. Nevertheless, there are examples of overhead costs that are not easily allocated to one product.
Activities broken down
Activities are actions, occurrences, jobs or any kind of work that are carried out for a particular reason. There is a reason or an aim that drives the process of an activity. Activities may range from the process of sketching out the product, assembling the equipment to be used throughout the process, to the point of actually using the equipment and disseminating or spreading the products to the final users.
What are the advantages of using activity based costing methods?
Activity based costing improves the cost structure in three major ways:
Basis for Non Traceable Cost
One advantage of activity based costing is that it gives you a clue to the exact cause of some activities that were initially not evident. It disrupts the substance of different indirect costs. In the sense that, it brings a clearer view on costs that have been tagged as indirect. For instance we have depreciation, allowance, salaries, service and so on. When you make use of the activity based costing method, costs that have been previously tagged as indirect, then can now be traced to the exact activities.
Balance Unit Cost
The activity based costing method will also help to balance the unit cost of products with low volume and higher volume. It provides a fresh foundation for allocating indirect or overhead costs to products. This way, costs are assigned as a result of the activities that result in the cost as opposed to measures of volume. Typical examples are direct labor costs or machine hours. So there will be a change of overhead cost of different measures of volume. Activity based costing moves the overhead costs from high volume products to low volume products. Thereby increasing the unit cost of the low volume products.
Accuracy
The activity based costing gives a more factual and correct data of the overhead cost. The distribution of the running cost is more detailed and can be relied on. It does this by broadening the total amount of cost pools that can be developed to gather indirect costs. It separates costs into pools by the specific activities, as opposed to joining all the costs under one general company pool.
Activity based costing method- Relatable Example
In order to break down the activity based costing method, we decided to look into a relatable example. Let us put into consideration a particular company A that is into manufacturing. Company A has an annual waste disposal cost of NGN100,000. The total hours for work (the labor hours) directly affects the waste disposal cost. For this work year, Company A had a total labor hours amounting to 4,000 hours. This is an example of a cost driver. In order to get the value of the cost driver rate, we will divide the NGN100,000 annual waste disposal cost by the total number of work hours which is 4000 in this case. This will therefore amount to NGN25 cost driver rate.
In the manufacturing of a particular product, company A had to use the waste disposal service on 15 different occasions. This simply means the overhead cost of this particular product will be multiplying the cost driver rate with the number of times the company disposes of waste. That is NGN25 multiplied by 15. That is equal to NGN375.
In conclusion
Although the work hours(also known as the labor hours) and the equipment hours(also known as machine hours) could be an adequate factor for companies to begin with in order to have a comprehensive knowledge of possible running costs, activity based costing techniques can be used instead. This is because the activity based costing will provide more consideration and data of the overhead or running cost.