Activity-Based Costing: Pros, Cons, and Examples

Assigning cost based on anything other than the general ledger (GL) can lead to variances that may cause stakeholders to question the results. Addressing any deviation from the general ledger is warranted and will lead to more confidence in the costing data. It can be considered as the modern alternative to absorption costing, allowing managers to better understand product and customer net profitability.

• Additionally, ABC can help businesses better understand customers’ needs and how much they’re willing to pay for a product or service.
• It assigns costs to activities based on how they contribute to the overall cost of a product or service.
• The ABC method allocates costs based on similar activities, such as using specific equipment that is expensive to maintain.

To help cost objects and process owners make informed decisions, the results of an ABC costing study should be presented in a clear and organized format. Because this is usually not a trivial expense, the results of the costing study must be communicated. Implementing an ABC system requires an investment of time and resources, but the rewards are well worth it. Organizations can improve their bottom line and become more competitive in their industry by achieving a more strategic approach to cost management. The broad range of issues noted here should make it clear that ABC tends to follow a bumpy path in many organizations, with a tendency for its usefulness to decline over time.

The 4 types of activity-based costing activities

Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders. Businesses with new product lines might consider adding this process to see how it affects their bottom line. For example, a tech company that produces smartphones might use this process to determine the cost of storing parts. By determining the costs of storage facilities and keeping up the utilities to keep the parts stored at the correct temperature, the company can see how this affects the cost of producing the phones. Activity-based costing is an accounting method that one can apply to several aspects of a business.

The ABC analysis shows that the total cost of production for Swifty Feet is actually $53.91 per pair, not $55.00 as originally calculated. These differences in costs of production have implications for profit planning, production scheduling and spending for marketing campaigns. Organizations can use activity-based costing to build a competitive https://accounting-services.net/the-disadvantages-advantages-of-activity-based/ advantage by allowing them to make better decisions about how they allocate resources. Using the results from steps 1 and 2, the activity pool’s budget is finalized. Human resource costs could be included as indirect administrative or management costs. This difference may seem small, but it can significantly impact your business.

Activity-Based Costing Benefits

By understanding which activities drive the most costs, you can identify areas to improve efficiency and reduce waste. The motive of the ABC method of costing is to allocate the overheads involved in the activity. This helps us track whether the cost of the activities is in line with the industry’s standards. Therefore, it acts as a tool for measuring the cost of activities and thus helps in decision-making. Activity-Based costing is allocating costs to the activities involved in the production.

• Assigning cost based on anything other than the general ledger (GL) can lead to variances that may cause stakeholders to question the results.
• To reduce this cost, run an ongoing analysis of the cost to maintain each cost pool, in comparison to the utility of the resulting information.
• The cost pool for this example could include purchasing raw materials, which would be ink.
• Activity-based costing (ABC) is a costing method that assigns overhead and indirect costs to related products and services.
• The typical company uses a variety of distribution channels to sell its products, such as retail, Internet, distributors, and mail order catalogs.
• The goal is to minimize this effect and assign true costs (i.e., vendor cost) where possible.

It can be defined as a system of costing that recognizes activities involved in producing a product and then traces the cost incurred in performing each activity. Overall, the benefits of activity-based costing make it a valuable tool for businesses to improve their bottom line. For activity-based costing to be effective, your organization must have a detailed breakdown of each activity performed by its employees. For example, if you’re using this method to budget for employee salaries, you’ll need to know exactly what each employee does daily to properly assign costs based on that work.

The Disadvantages & Advantages of Activity-Based Costing

Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products. Use activity drivers to apportion the costs in the secondary cost pools to the primary cost pools. As finance leaders adopt more detailed costing methods, they should also consider the calculation frequency and the costing time period. A move from year-to-date to monthly or quarterly periodic costing will improve opportunities for trending. For many organizations, a quarterly processing cycle will strike the right balance between a timely refresh of costing data and demands on staff time.

• The cost driver rate is used in activity-based costing to calculate the amount of overhead and indirect costs related to a particular activity.
• However, some indirect costs, such as management and office staff salaries, are difficult to assign to a product.
• Identifying and assigning costs to each activity lets you better understand the cost of your products or services and make more informed decisions about pricing specific products and resource allocation.
• The disadvantages of the ABC method include it being expensive to implement, as well as maintenance, being a time-consuming process, being used only for internal reporting, and having the possibility of some excluded costs.
• Now that you have an idea of what ABC is all about, it’s time to understand how it works in real life.

ABC considers the costs of resources used in each activity, which are then assigned to products based on their use. This makes it easier for managers to determine which products are profitable and which are not, so they can better decide where to focus their efforts. The most common management reaction to an ABC report is to reduce the quantity of activity drivers used by each cost object. In addition, it can be useful for the controller to monitor the actions taken by management in response to ABC reports. If management is no longer taking any action, then it may be necessary to shut down the ABC reporting system; otherwise, the company is incurring a reporting cost without benefiting from any actions to enhance operations. This is the most critical step in the entire process, since we do not want to waste time with an excessively broad project scope.

Disadvantages of Activity Based Costing

In today’s competitive business environment, accurately understanding your fixed and variable costs is crucial for success. This innovative method offers a more accurate and detailed understanding of how you’re using resources and racking up costs. The ABC provides information about the cost incurred on each production activity; with that help, the management can decide which activity is profitable to perform domestically and which is required to be outsourced. Management can outsource any activity if that incurs a higher cost domestically than outsourcing. Activity- Based Costing is a costing system that focuses on the activities conducted in producing the products. It is the system in which the cost of various production activities is identified, and the final cost is added to the product.

Traditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received. In this way, long-term variable overheads, traditionally considered fixed costs, can be traced to products. Additionally, managers can identify process improvement and cost savings opportunities by understanding the cost drivers of different activities. As a result, understanding cost drivers in activity-based costing leads to more accurate outputs and can be highly beneficial for businesses.

Disadvantages of Activity-Based Costing

Activity-based costing may also generate value in areas that are not immediately apparent. For example, a more detailed approach to costing for areas of indirect or semi-direct costs can provide valuable insights into the true cost of patient encounters. At the same time, this helps mitigate the distortion of results that can occur when these costs are allocated solely based on statistics such as revenues, expenses, or FTEs.

The important and common fact about both costing systems is that the cost is assigned to the product at the second or final stage. Finally, ABC can be difficult to use in decision-making if managers are unfamiliar with the technique. If your organization’s managers are uncomfortable using ABC data, stick with traditional costing methods. It accomplishes this by breaking down costs into the activities that drive them instead of assigning costs to products or services based on historical patterns or what is easiest to track. Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base.

Activity-Based Costing vs. Full Costing

Its purpose is to include indirect costs to have a better understanding of the overall costs. Activity-based costing is different from standard-based costing and other traditional methods. These other methods do not account for indirect costs and focus only on specific costs that go into the product, such as labor or materials. Cost drivers can be internal (such as labor hours, material usage, etc.) or external (such as industry trends, economic changes, etc.). You can also identify cost drivers for a specific activity, such as marketing campaigns or manufacturing processes. Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation, utilities, or salaries—traceable to certain activities.

Activity-based costing then assigns those costs back to the product or service so that companies know how much they spend on each specific activity and can make better decisions about reducing those costs. This information can be used to make decisions about where to cut costs and how to improve efficiency. Second, it creates new bases for assigning overhead costs to items such that costs are allocated based on the activities that generate costs instead of on volume measures, such as machine hours or direct labor costs. Similarly, semi-direct costs, such as clinical administration departments’ expenses, can be redirected to specific direct departments to facilitate full-cost assignment.