Activity based costing (ABC)

Activity based costing ABC is a method for assigning costs to products, services projects, tasks, or acquisitions, based on

• Activities that go into them.
• Resources consumed by these activities.

ABC contrasts with traditional costing , which sometimes assigns costs using somewhat arbitrary allocation percentages for overhead or the so-called indirect costs. Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities. As a result, ABC and traditional cost accounting can estimate cost of goods sold and gross margin very differently for individual products. Contradictory and uncertain cost estimates can be a problem when management needs to know exactly which products are profitable and which are selling at a loss.

STEPS to implement ABC

Activity-based costing requires to use the following four steps:

1. Identify the activities that consume resources and assign costs to those activities. Purchasing materials would be an activity, for example.
2. Identify the cost drivers associated with each activity. A cost driver is an activity or transaction that causes costs to be incurred. For the purchasing materials activity, the cost drivers could be the number of orders placed or the number of items ordered. Each activity could have multiple cost drivers.
3. Compute a cost rate per cost driver unit. The cost driver rate could be the cost per purchase order, for example.
4. Assign costs to products by multiplying the cost driver rate times the volume of cost driver units consumed by the product. For example, the cost per purchase order times the number of orders required for Product A for the month of December would measure the cost of the purchasing activity for Product A for December.

Advantages of Activity Based Costing

1. Activity Based Costing helps to reduce costs by providing meaningful information on the opportunities available for reducing costs.

2. Activity Based Costing is working only on the activities. Hence, the management can take the quality decision by knowing the nature of each activity.

3. The activities can be classified into two i.e. value adding activities and non-value adding activities. The Activity Based Costing helps the management on focusing the forces on value adding activities and eliminate non-value adding activities.

4. The accurate allocation of costs to various products leads to proper pricing policy.

5. The statement of expenditure is prepared on activity-wise and compare the costs of each activity with one another to find the activities which are to be eliminated or improved for better performance.

6. The accurate cost information helps the management to adopt productivity improvement approaches like Total Quality Management (TQM), Business Process Re-engineering (BPR) etc.

7. The management can take make or buy decisions by considering the cost of manufacture of a product or sub contract the same with an outside agency through Activity Based Costing analysis.

8. If the available resources can not be used properly even after sub contracting the manufacture of any product, the management can do the activity of manufacture of such a product within the firm.

Disadvantages of Activity Based Costing

1. Activity Based Costing is not useful to small companies.

2. If the overheads are relatively small, there is no use of Activity Based Costing.

3. Some companies are producing only one product or few products. If so, the Activity Based Costing cannot be applied.

4. Activity Based Costing method should not be used to prepare monthly profit statements.

5. It becomes difficult to identify Cost Pools and then appropriate and respective Cost Drivers.

6. Implementation and Calculation process can be lengthy and time consuming.