What is Activity-based Costing?
A crucial aspect of achieving business prosperity is minimizing overhead expenses and optimizing earnings. However, before you can accomplish this, it's necessary to consider all direct and indirect expenditures. Activity-based costing (ABC) is a method that has advantages over other accounting methods. It helps allocate costs more accurately.
What is activity-based costing?
Activity-based costing is a method of determining the cost of products that includes indirect expenses. Tracking resource use and pricing final outputs is a process. The objective of activity-based costing is to allocate particular resources to items. This aids team managers in identifying the activities that escalate production expenses, enabling them to make more informed decisions regarding pricing and production.
Activity-based costing includes the following steps:
- Determine the tasks necessary to finish a product.
- Identify expenses linked to activities and items, then allocate them to various groups.
- Allocate particular drivers to each group, such as an hour or unit.
- Determine the rates of cost drivers by dividing the total overhead expenses by the overall cost drivers.
- Calculate the cost driver rate for each pool by dividing the total overhead by the total cost drivers.
- Multiply the rate of your cost driver by the total number of cost drivers.
You can draw a comparison between activity-based costing and absorption costing. Absorption-costing pertains to the equal distribution of overhead cost values across all stock. This accounting approach fails to consider products that might have elevated indirect expenses, unlike activity-based costing.
Activity-based costing advantages
Using activity-based costing has several advantages, such as:
It provides a precise and authentic manufacturing cost for particular products
Activity-based costing gives managers more accurate production costs. This can help businesses make better decisions about what products to make or find cheaper ways to produce them. This can also be beneficial in setting prices for specific products.
Activity-based costing makes it easier to understand manufacturing costs and gather data. The majority of management team members are capable of determining the expenses associated with each task, given they have the required information. This could also assist in making manufacturing choices that influence cost determination.
It enables you to allocate particular overhead expenses to costlier products
Activity-based costing allows for budget allocation based on the specific needs of each area. This means that not all products are given equal value. Some products may be costlier to produce, depending on their indirect costs. This can also help identify costs that apply to multiple manufacturing product pools, making resources more valuable.
It enables you to assess the effectiveness of productions and implement enhancements
This approach enables supervisors to allocate value to overhead costs, handling them as though they were direct expenses. By breaking down the indirect cost of each activity, they can make improvements. The activity-based costing approach can be utilized by managers to assess aspects such as managerial impact, process efficiency, and the total expense of various departments.
It provides you with more precise information for profit margins
Activity-based costing helps improve profit margins by including non-manufacturing or indirect costs that may have been overlooked.
Possessing precise profit margins can assist business executives in making crucial choices. It can help lower production costs and increase profits by using smart pricing strategies.
With the use of activity-based costing, managers can effortlessly pinpoint products that have minimal or no worth. They can use this information to take products out of stock and use manufacturing resources for more profitable items.
It also makes it easier to identify products that may be wasteful in terms of required resources. Certain goods might not just be of inferior quality, but also consume essential resources.
It offers advantages in sectors where other techniques fail
Traditional costing methods don't always work in certain industries, such as the service industry. This is due to the fact that service sectors have very low direct expenses.
You can use activity-based costing in certain industries. This involves assigning costs directly to the specific services offered. This means you can use it to improve results and pricing in industries that others overlook.
Activity-based costing disadvantages
When selecting the appropriate approach, it's crucial to weigh the possible drawbacks of activity-based costing. Here are a few potential disadvantages to consider:
It may take more time
Activity-based costing can be a more time-consuming process. Team members must manually assess the costs of each product instead of dividing total costs equally among all products. They must undertake the procedure of segregating products into various groups.
Businesses may need to assign a team to this specific task, but they may also choose to outsource it. This could be a more effective approach as it typically necessitates a group of managerial-level staff. When you hire a team that specializes in activity-based costing, they are already familiar with the programs. This makes the outsourcing process easier.
Collecting precise data may demand additional resources
Collecting information for specific products can be both labor-intensive and expensive. Businesses might need to hire or assign team members for the task, impacting payroll. You may also need to buy data collection software.
Certain companies opt to delegate the procedure, which can also incur expenses for the business. Nonetheless, there might be alternatives accessible to help simplify the procedure for a more productive and cost-efficient process.
The task could be challenging without immediate access to data
Depending on the manufacturing systems or programs that you use, the information you need may not always be readily available. Collecting the data you need may require the use of specific software.
Furthermore, the reports used to collect this data may not follow traditional accounting principles. This can make it challenging for some teams to track the information accurately.
All teams involved in production and manufacturing might require training on the newly introduced activity-based costing procedures and software. Nonetheless, once this is accomplished, the process generally becomes simpler for all participants. Collecting the necessary data can be advantageous, provided you have the appropriate tools and team members.
This might not be a feasible choice for smaller companies
Small companies with low overhead costs may not benefit from using activity-based costing as much as larger companies. They tend to use market-based costs more often than activity-based costing when calculating data.
You may most often find activity-based costing in the manufacturing industry. However, it is proving to be beneficial in other industries, too.
KEY POINTS
- Activity-Based Costing (ABC) is a technique for allocating indirect and overhead expenses—like wages and utilities—to goods and services.
- The cost accounting method known as the ABC system is centered around activities, which are defined as any event, work unit, or task that has a specific objective.
- A cost driver is an activity, like placing purchase orders or setting up machines.
- The cost driver rate is calculated by dividing the total cost pool by the cost driver. It helps determine the overhead and indirect costs for a specific activity.
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