Here at Keeping Your Balance, we always strive to keep you apprised of the key concepts and innovations in accounting procedures. Today, we take a look at a relatively new methodology called Activity-Based Costing, also known as ABC.
What is Activity-Based Costing
Activity-based costing is a methodology that uses what is generally considered to be a more logical approach to assigning overhead costs to your products or services. The Chartered Institute of Management Accountants (CIMA) defines activity-based costing as:
“An approach to the costing and monitoring of activities, which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilize cost drivers to attach activity costs to outputs”
Comparison to Traditional Costing
In the more traditional approach to costing, overhead costs are applied using a somewhat arbitrary method. A common denominator, such as labor hours or machine hours is used to determine a proportion of the overhead costs, which is then added to the actual direct costs, to arrive at a resulting “total product cost”.
How does activity-based costing work?
Activity-based costing differs from the more traditional methods of costing in that it assigns the costs to the activities that are actually the cause of those overhead costs. Once that has been accomplished, those costs are then assigned to the products that actually require those activities.
The steps in the process go something like this:
- Identifying the activities involved in the production process.
- Gathering the costs into pools for each activity
- Identifying a measure, or cost driver, for each activity (these could be different measures for different activities, e.g. hours, square footage, etc.)
- Calculating the units of the cost driver to be applied to each activity, and thus the rate or proportion to be applied.
- Calculating the costs of each activity
- Applying those costs to products, based on their usage of those activities.
When should you use activity-based costing?
Activity-based costing has proven to be a valuable tool for business financing, costing, and accounting.
It will be useful whenever you’re trying to accomplish any of the following, among its other applications:
- Fixing the price of a product or service
- Identification of processes, products, activities, or even entire departments that aren’t operating efficiently
- Achieving cost-control, at the product level or departmental level
- Identification of unnecessary costs that could be eliminated.
- Identification of profitable products, activities, or departments to which more resources should be allocated.