Activity-Based Costing ABC: Method and Advantages Defined with Example

Here are some key differences between activity-based costing and absorption costing. Suppose, P1 requires 5 labor hours and P2 requires 10 labor hours at a rate of $ 2 per hour. „Activity-Based Costing and Its Advantage for Companies.“ BusinessEssay, 7 Jan. 2021, business-essay.com/activity-based-costing-and-its-advantage-for-companies/. Organizations that use activity-based costing cut right across different industries. Manufacturing companies, as well as the service sector, find activity-based costing a useful model for pricing.

It depends heavily on Activities Based Costing as a source of its information. For example, PCB Ltd. is manufacturing circuit board for computer monitor, TV and aeroplane. Time for manufacturing each type of circuit board is the same. However, the circuit board for the aeroplane is tested for a longer time by highly paid technicians because it must be 100% error-free. As some products are produced in large batches and some in small batches. Your access to this site was blocked by Wordfence, a security provider, who protects sites from malicious activity. Emphasize resources whose consumption varies significantly by product and product type; look for diversity.

Activity-based costing definition

In this way, long-term variable overheads, traditionally considered fixed costs, can be traced to products. Activitybased costing systems are more accuratethan traditional costing systems. This is because they provide a more precisebreakdown of indirect costs. However, ABC systems are more complex and more costly to implement.

Increased knowledge of production activities leads to process improvements and reduced costs. ABC requires identifying the activities involved in the production process and assigning costs to these activities . This provides management with a better view of the detailed activities involved and the cost of each activity. Managers are more likely to focus on improving efficiency in the most costly activities, thereby reducing costs. Activity-Based Costing is used to a greater degree in the manufacturing industry as it helps to improve the reliability of cost data. It allows a firm to create viable pricing strategies that prove fruitful for them.

Benefits of Activity-Based Costing to My Organization?

This is done by dividing the estimated overhead costs by the estimated level of cost driver activity . Figure 3.4 „Predetermined Overhead Rates for SailRite Company“ provides the overhead rate calculations for SailRite Company based on the information shown in the previous three steps. A method of costing that uses several cost pools, and therefore several predetermined activity based costing overhead rates, organized by activity to allocate overhead costs. In traditional costing system, overhead costs are assumed to be influenced by only units produced. It means, in traditional costing system, cost of batch level, product level and facility level activities is fixed costs, i.e., costs of these do not change as production volume changes.

• Use the 80/20 rule to identify the 20% of items representing 80% of costs.
• It cannot be assured that a „time bomb“ is not still hidden somewhere in its cost information that will lead it to make a critical, if not fatal, decision in the future.
• In advanced manufacturing environment and technology where support functions overheads constitute a large share of total costs, ABC provides more realistic product costs.
• However, the circuit board for the aeroplane is tested for a longer time by highly paid technicians because it must be 100% error-free.
• Describe the Benefits and Drawbacks of GPK, RCA. GPK can be described as marginal planning and cost accounting, where RCA is Resource Consumption Accounting.
• Activity-Based Costing data will have to be linked to the evaluation of employees if you are looking to implement the system successfully.

The activity-based method is a _______ accurate method of allocating complex overhead costs. Identify the four steps used to accumulate and allocate costs in an activity-based costing method. Use departmental overhead rates to assign costs to cost objects. The departmental overhead rate method uses a four-step process to allocate cost object.

Activity-Based Costing

Activity-based costing also makes it possible for businesses to increase their operational efficiency. Since activity-based costing focuses on processes, https://www.bookstime.com/ it is easy to determine alternate processes that will yield the same results faster or at a lower cost (Kimmel, Kieso, & Weygandt, 2010).

All manufacturing costs are classified as material, labor, or overhead and assigned to products regardless of whether they drive or are driven by production. Finally, top executives may be reluctant to abandon existing product cost systems in favor of a new approach reflecting a radically different philosophy. However, implementing an ABC system does not require an abrupt overhaul. Cheap, powerful software tools allow businesses to develop new cost systems offline from official accounting systems for strategic purposes. Companies don’t have to commit their entire accounting system to activity-based costing to use it. On the front side of the business, understanding which products have the highest margins might dictate how you spend your marketing dollars, segment your customers, and focus your sales efforts.

It can be more time-consuming

List 2 advantages and 1 disadvantage of participative budgeting. Describe the Benefits and Drawbacks of GPK, RCA. GPK can be described as marginal planning and cost accounting, where RCA is Resource Consumption Accounting.

• ABC produces more accurate costing of products by essentially converting broad indirect costs into direct costs of production.
• The assembly department uses direct labor hours as their allocation base and has 50,000 direct labor hours.
• For example, if a company spends a lot of money on labour but not on materials, the traditional costing method would assign a high cost to the labour but not to the materials.
• The management can identify cost drivers and activities that are not direct to product manufacturing.
• A third challenge is having excellent quality data and the processes and systems to support its generation and maintenance.

The results showed that ABC method is significantly and positively related to production process efficiency. Conclusively, rather than allocating overhead on the basis of one variable, such as direct labor, ABC effectively uses multiple cost drivers to present a more accurate foundation for overhead costs allocation. It was recommended that a clear understanding of ABC method and its effective implementation will help gain competitive advantages and achieve higher level of productivity performance of manufacturing companies.

It gives you a realistic and more accurate production cost of specific items

A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests, consumed power, purchase orders, quality inspections, or production orders. Divide the activities into cost pools, which includes all the individual costs related to an activity—such as manufacturing.

ABC does not confined itself to the allocation to indirect costs to departments as it is done in the conventional costing but it identifies individual activity as the lowest unit for indirect cost allocation. Costs allocated to each activity represent the resources consumed by it. ABC provides the detailed insights necessary to identify costs that can be reduced without adverse effects on clinical operations and quality of care.

Disadvantages

Traditional method allocates overheads first to the individual departments, whereas activity based costing assigns over heads to each activity first. – Activity based costing is more technical and time consuming, while traditional method or system is quiet straight forward. With ABC, the costs of resources used in activities are assigned to the activities based on the amount of time the resources are used or the amount of the resources used. The costs of activities are then assigned to products and services based on the amount of the resources used in the activities.

• Nonetheless, it is difficult to use activity-based costing in the creative arts sector because each product goes through a unique process; activity-based costing can only apply in general terms under such conditions.
• The idea is to link the cost of all the activities to the products that utilize those processes.
• Additionally, when you outsource this task to a team that specifically focuses on activity-based costing, the team is usually already familiar with the programs.
• This system is specifically useful in recognizing and ear-marking some of the matters business activities which are a stress or burden on the business i.e. wasteful or non value adding services.