Activity Based Costing Explanation

activity based costing examples

ABC can help us to provide more accurate information regarding production cost to set a proper price in a competitive market. It helps the management to understand cost and driver, so we will be able to cut the nonvalue added cost and focus on quality improvement only. Management also is able to rank the cost to be reduced if they wish to join a price war with competitors. The activity-based costing bases on the activity in the production and links it to the cost pool. A cost pool is a group of overhead cost which we are unable to allocate to each product. By giving a detailed breakdown of costs and the activities that drive them, the accounting system can help you make more informed decisions about pricing, production, and process improvements.

Its overall objective is to improve efficiency and effectiveness of an organization in securing its markets. It depends heavily on Activities Based Costing (ABC) as a source of its information. (f) Improved cost-basis available both at head office and plant level for better decision making. (e) Once processes are re-engineered, then the new costs must be tabulated.

Unit Cost Card Using Activity-Based Approach

The cost of making the product under the ABC method is about half the amount allocated under the traditional method. Another challenge is that activity-based costing can be complex, making it difficult for managers to understand and use the information correctly. Finally, activity-based costing can sometimes lead to distorted or inaccurate cost information if not used properly.

Activity-based costing requires a complicated set of actions in order to achieve the best outcome. 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. Failing to take all of your costs into consideration could result in setting your prices too low. Pricing products can be one of the most difficult decisions you make in business.

Difference Between Traditional Costing and Activity-Based Costing

Shoe and Sons can better understand the origins of their costs thanks to the activity cost pool, enabling them to have better control over those costs. Activity-based costing assigns costs based on resources consumed by each activity rather than applying them equally across all activities. Trendy Clothing would repeat this process for each activity and cost driver to determine the activity-based costs for each product line. 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.

  • As a result, traditional costing can give an inaccurate cost of making each product.
  • It is instrumental in complex organizations with multiple products and services and when allocating costs to specific activities or processes is needed.
  • Activity-based costing has become increasingly popular as organizations seek to improve their cost management processes.
  • A more accurate classification of the costs than the company incurs throughout the production process.

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

There are a few key things to keep in mind when implementing ABC:

It is common for activity costs to respond in a manner comparable to one another; that is, they share the same cost driver, often known as the element that causes a change in the cost of an activity. As a result, it is generally thought that activity-based costing contributes to presenting a more accurate picture of the behavior of costs. As a result, the activity-based approach leverages activities rather than functional divisions (also known as Cost activity based costing examples Centers) to absorb overhead costs. One of the most fundamental characteristics of functional departments is the tendency for such departments to include various activities that might result in various expenses and behave in various ways. We usually use absorption costing for the traditional which does not reflect in real situations. In the modern way, we will use ABC that calculated based on cost drivers, the activities that increase the cost.

  • Activity-Based Costing is a method of assigning indirect and overhead costs to each of your products or services – giving you a better idea of their actual costs.
  • It assumes the activity will consume resources and will generate results.
  • There is a very high probability of an ABC system providing a different picture of product costs than what is provided by the traditional system.
  • Short-term costs will be incurred within the next year or two, while long-term costs will extend beyond one year.
  • Activity based budgeting is an approach to budgeting that lays emphasis on budgeting the costs of activities necessary to produce and sell products and services.

The ABC system breaks down manufacturing overhead into cost pools such as machines, raw materials, salaries, utilities and anything else that costs money. Each cost pool is then filled with individual cost objects (items) like electric, water, gas and all the rest that goes into making a product. Activity-based costing (ABC) is a methodology for more precisely allocating overhead costs to products and services.