Key Takeaways:
- Understand what Activity Based Costing (ABC) means and why it's used for accurate overhead absorption
- Learn how cost drivers and cost pools form the backbone of ABC
- See the stepwise ABC process and compare it directly with traditional costing, including a calculation example
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Cost & Management Accounting has evolved to provide managers with tools for better cost control and decision-making. One such modern approach is Activity Based Costing (ABC), a technique designed to allocate overheads with much greater precision than older methods. If you’ve ever wondered why two similar-looking products sometimes have wildly different cost structures! ABC offers a clear answer. Let's examine its principles, process, and practical utility.
Introduction
Traditional methods often spread overheads broadly, giving only a rough estimate of actual costs. ABC, however, digs deeper. It recognizes that products and services consume activities, and activities in turn consume resources. As a result, ABC assigns costs based on real resource usage, not arbitrary averages. This shift enables better pricing, profitability analysis, and process improvement.
Think about a factory: not every product requires the same setup, inspection, or packaging effort. ABC reveals these hidden variations.
Definition of Activity Based Costing
Activity Based Costing (ABC) is a modern overhead absorption method that assigns indirect and overhead costs to products or services based on the specific activities and resources they consume. Unlike traditional costing, which often uses a single basis such as machine hours or labor hours, ABC recognizes multiple activities and uses appropriate cost drivers to trace costs to products more accurately.
ABC is especially valuable for organizations with diverse products, multiple production lines, or complex processes. It provides a more realistic picture of product or service costs and supports informed managerial decision-making.
Cost Drivers and Cost Pools
a. Cost Pools
A Cost Pool is a grouping of individual costs related to a specific activity. For example, all costs related to machine setups such as labor, materials, and utilities that can be gathered in a 'setup' cost pool. Similarly, costs for quality inspections, order processing, or maintenance are pooled separately. This organization makes it easier to assign costs logically.
b. Cost Drivers
Cost Drivers are the measurable factors that cause costs to be incurred for an activity. They provide the link between activities and the products or services that consume them. For instance, the number of machine setups, hours spent on quality checks, or number of purchase orders are common cost drivers.
ABC distinguishes between different types of drivers:
- Transaction drivers – count the number of times an activity occurs (e.g., number of setups)
- Duration drivers – measure the time taken to perform an activity (e.g., hours of maintenance)
Choosing the right cost driver is essential for accuracy. If a product requires more setups or longer inspection times, the cost assigned to it will rightfully increase.
Steps for ABC Implementation
- Identify and Define Activities
List all major activities involved in the production or service process. Examples include machine setup, order processing, quality inspection, packaging, and dispatch. - Assign Costs to Activity Cost Pools
Accumulate all indirect costs associated with each identified activity into separate cost pools. Each pool represents the total cost of performing that activity. - Select Appropriate Cost Drivers
Determine the most logical cost driver for each activity. This could be the number of units produced, number of orders processed, or hours spent on an activity. - Calculate Cost Driver Rates
For each activity cost pool, divide the total pool cost by the total number of cost driver units. This gives the cost per unit of activity. - Assign Costs to Products or Services
Multiply the number of cost driver units consumed by each product or service by the cost driver rate. The result is the overhead cost assigned to each product or service based on its actual consumption of activities.
ABC vs. Traditional Absorption Costing
| Feature | Traditional Absorption Costing | Activity Based Costing (ABC) |
|---|---|---|
| Basis of Overhead Allocation | Single cost driver (e.g., labor/machine hours) | Multiple cost drivers linked to activities |
| Accuracy | Lower, may distort product costs | Higher, reflects actual resource usage |
| Complexity | Simple to apply | Requires detailed analysis |
| Suitability | Homogeneous products/processes | Diverse products and complex processes |
| Decision Support | Limited | Strong, supports process improvement and pricing |
Example: Calculation of Cost Per Activity
Suppose a manufacturing company makes two products, A and B. It incurs the following overhead activities for a month:
- Machine setups: Total cost = ₹60,000; Number of setups = 30
- Quality inspections: Total cost = ₹40,000; Number of inspections = 80
- Product A: 10 setups, 50 inspections
- Product B: 20 setups, 30 inspections
- Calculate Cost Driver Rates:
Machine setup rate = ₹60,000 / 30 setups = ₹2,000 per setup
Inspection rate = ₹40,000 / 80 inspections = ₹500 per inspection - Assign Overhead to Products:
Product A: (10 setups × ₹2,000) + (50 inspections × ₹500) = ₹20,000 + ₹25,000 = ₹45,000
Product B: (20 setups × ₹2,000) + (30 inspections × ₹500) = ₹40,000 + ₹15,000 = ₹55,000
This allocation reflects the real resource usage by each product. Notice how Product B, with more setups, absorbs more setup cost, while Product A, needing more inspections, absorbs more inspection cost. Compare this to a traditional method where both might have received overhead based only on machine hours, masking these critical differences.
Activity Based Costing is a powerful approach for understanding costs accurately, especially when operations are complex and overheads are significant.