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Activity-based costing (ABC) is a method that assigns production costs to specific activities, providing a detailed breakdown of overhead expenses and helping businesses identify profitable products. While ABC offers advantages like accurate budgeting and product pricing, it is more complex and not 100% accurate compared to traditional costing methods. Implementing ABC involves identifying activities, grouping costs, and calculating cost driver rates to allocate overhead effectively.

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5 views

Activity-Based-Costing-3

Activity-based costing (ABC) is a method that assigns production costs to specific activities, providing a detailed breakdown of overhead expenses and helping businesses identify profitable products. While ABC offers advantages like accurate budgeting and product pricing, it is more complex and not 100% accurate compared to traditional costing methods. Implementing ABC involves identifying activities, grouping costs, and calculating cost driver rates to allocate overhead effectively.

Uploaded by

Jhoy Periña Bas
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as DOCX, PDF, TXT or read online on Scribd
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What is activity-based costing?

Activity-based costing (ABC) is a system you can use to find production costs.
It breaks down overhead costs between production-related activities. The
ABC system assigns costs to each activity that goes into production, such as
workers testing a product.

Manufacturing businesses with high overhead costs use activity-based costing


to get a clearer picture of where money is going. Because ABC gives specific
production cost breakdowns, you can see which products are actually
profitable.

By using activity-based costing, you can:

 Take into consideration both the direct and overhead costs of creating each
product
 Recognize that different products require different indirect expenses
 More accurately set prices
 See which overhead costs you might be able to cut back on

Activity-based costing vs. traditional costing


ABC provides an alternative to traditional costing. Traditional costing applies
an average overhead rate to direct production costs based on a cost driver
(e.g., hours or volume).

But, some production-related activities use more overhead expenses than


others. As a result, traditional costing can give an inaccurate cost of making
each product.

Traditional costing is simpler but less specific than activity-based costing. You
might consider going with traditional costing if you only make a few products.

You may also use traditional costing for reporting externally (e.g., to investors)
and activity-based costing for reporting internally (e.g., to managers).

Benefits and drawbacks of activity-based


costing
Although an activity-based costing system gives you accurate production cost
details, it can be difficult to implement. That’s why you should consider the
pros and cons before deciding if it’s right for your business.

Benefits of activity-based costing


ABC costing can help with:

 Budgeting
 Overhead decisions
 Product pricing

Budgeting
When creating your budget for the year, you probably try to get as specific as
possible when it comes to your incoming and outgoing money.

Activity-based costing can help you to set an accurate budget that breaks
down exactly where your money is going—and which products are the most
profitable.

Overhead decisions
The ABC system shows you how you use overhead costs, which helps you
determine whether certain activities are necessary for production.

Activity-based costing helps you identify where you’re wasting money. If you
find that some activities cost more than they should, you can find new
methods to do something. Or, you can cut out steps (and even products)
entirely.

Product pricing
Another benefit of ABC is accurate product pricing. Pricing products can be
one of the most difficult decisions you make in business.

Failing to take all of your costs into consideration could result in setting your
prices too low. As a result, you might not wind up with a healthy profit margin.

With an ABC system, you can assign costs to each activity in the production
process. This shows you all the costs that go into producing a specific
product. You can use this data to set a price that more accurately accounts for
how much it costs you to create the product.

Drawbacks of an ABC system


Before implementing this type of costing method, consider the cons:

 Complex
 Not 100% accurate

Complex
Activity-based costing is more complicated than traditional costing. Instead of
general overhead costs and production-related activities, you need to be
specific.

How much time is Employee A spending on Activity XYZ? What about


electricity—how should you split up utility costs by activity?

Getting into the weeds can make it difficult to track data without an elaborate
(and tried and true) system. Not to mention, some businesses don’t have the
job positions and resources to manage an ABC system.
Not 100% accurate
Unfortunately, there isn’t a costing method that gives you a completely
accurate breakdown of your costs. So although an ABC system is more
accurate and detailed than traditional costing, it isn’t 100% accurate.

For example, the ABC system requires employees to track how much time
they spend on each activity (e.g., research, production, etc.). Your employees
might miscalculate or even exaggerate their time spent working on an activity.

Activity-based costing calculation


Interested in using the ABC system in your business? To use this costing
system, you need to understand the process of assigning costs to activities.

Take a look at an activity-based costing formula you can use:

(Overhead for Cost Pool / Cost Drivers) X Amount of Activity Cost


Driver

Now, let’s take a step back and go over what exactly this means.

A cost pool is a group of individual costs associated with an activity. You can
create cost pools by identifying the activities that go into creating a product.
Once you’ve grouped your costs into a pool, find the total overhead. Keep in
mind that there’s no set number of groups you need to have.

A cost driver is something that controls changes in the cost of an activity.


Examples of cost drivers include units, labor or machine hours, and parts.
Assign cost drivers (you can have more than one) to each cost pool.

When you divide the total overhead in a cost pool by your total cost drivers,
you get a cost driver rate.

Step-by-step breakdown
Here’s a breakdown of the steps that go into activity-based costing:

1. Identify all the activities that go into creating a product (tip: if you spend
money on it, add it in!)
2. Separate each activity into groups (e.g., product line)
3. Find the total overhead for each cost pool
4. Assign activity cost drivers (units, hours, parts, etc. that control
changes in costs) to each group
5. Divide the total overhead in each group by the total activity cost drivers
to get your cost driver rate
6. Multiply the cost driver rate by the amount of activity cost drivers

Let’s say you allocate $10,000 in overhead to setting up 4,000 machines (your
cost drivers). Your cost driver rate would be $2.50 ($10,000 / 4,000). Now,
you want to know how much goes toward Product XYZ. Two hundred of the
machines you set up were Product XYZ. Your overhead costs for Product
XYZ were $500 ($2.50 X 200).

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