Definition and Explanation
The definition of activity-based costing is a management accounting approach to the costing and monitoring of activities which involves identifying the activities the bring about specific costs. It is a costing system that focuses on activities performed to make goods. The ABC method allocates direct and indirect costs to goods and services based on the level of activities a company requires to make and deliver them.
Electricity, phone bills, internet usage, rent, and even salaries are examples of costs that are more difficult to divide or allocate between units produced. Activity-based costing finds ways to divide or allocate these costs more proportionally or fairly in comparison to the traditional costing method. This way, you can write down a higher cost for units that use more of the stuff related to costs.
How is this overhead allocation process different from the traditional? The fact that a cause-and-effect relationship is established between the accounting object (product or service) and the financial result of the activity through a chain of basic operations (business processes).
These processes include both directly related to manufacturing (technological) and not related to it (marketing and management) activities. Each of the business processes can involve all kinds of existing resources. The use of the ABC method involves calculating the cost of each of the selected business processes with the subsequent assignment of its portion to the cost of a specific product. Thus, the cost of activities associated with the product is consistently added to the cost of production throughout the whole manufacturing and delivery process.
Advantages and Disadvantages of ABC Approach
There are some for and against arguments a company should consider before choosing the ABC costing system.
Pros:
- Focus on relevant factors
- More accurate overhead cost allocation
- More effective overhead cost control
- Better management of activities
- Can assist in distinguishing value-added activities
Cons:
- More costs to implement and maintain
- Need specialized knowledge
- More time consuming
Example
For instance, you have a small lemonade and cookies stand. This month, you sold 100 glasses of lemonade and 200 cookies for a total of 300 items. At the end of the month, you receive an electric power bill of $300. How will you divide the electric power bill between the cookies and lemonades? Simple. The $300 divided by 300 items sold equals $1 in electric power for each glass of lemonade or cookie.
What if you use more electric power to make one cookie compared to making the lemonade? Is it still fair to write down $1 of electric power for one cookie and $1 of electric power for one glass of lemonade? We should write down a bigger electric power cost for the cookies, right? This is where the activity-based costing comes in.
In our case, we know that we should write down a lower electric power cost for lemonades than for cookies. As a result, we might decide to sell our lemonades at a lower price than the cookies and sell cookies at a higher price compared to the lemonades. We know that electric power is not the only cost in making lemonades and cookies. Therefore, electric power is only one of the factors that will affect our final pricing decision and we have to consider other costs as well.
Here are the steps that a business would need to follow to implement this costing approach in real life.
- Identify activities and activity pools
- Directly trace or estimate costs to activities and activity objects
- Assign costs to activity cost pools
- Calculate activity cost driver’s rates
- Assign costs to cost objects
- Prepare reports.
Application
This costing method allows not only to trace how the cost of each type of product changes over time but also to identify the reasons for the appearance or change in overhead costs immediately at the time of their occurrence.
In addition, the business can establish the volume of these costs included in the cost of the final product at each stage of production more accurately, compared to the traditional method of cost distribution. The data obtained in this way serves as a very informative material for analyzing the structure of the cost of goods and making management decisions.
This method is attractive for companies that have a wide range of products and carry out numerous activities that involve large overhead costs for their production and delivery to the customer. However, as you can see from all the steps involved in its implementation, this system requires significant labor costs, since there will be more things to track and calculate.
