Introduction
As the business world of today is highly influenced and driven by globalization pressures, it is imperative that organizations should manage their financial and non-financial resources efficiently and effectively for gaining competitive edge in their respective marketplaces. Equally important is that organizations, particularly manufacturing businesses, should consume their resources and activities wisely so that the costs should be controlled and revenue could be generated. Therefore, the primary focus of this research is to make an important discussion about Activity-Based Costing (ABC) considering different dimensions.
Not only is the concept of Activity-Based Costing (ABC) illustrated based on literature review (gained with the help of extensive research) but the manner in which this costing technique improves the business processes and costing system are also discussed. To stimulate detailed understanding, Activity-Based Costing (ABC) is compared to the traditional costing (an outdated or obsolete) system. This is supported by a simple illustrated considering two products as to how the costs are allocated or assigned when using any of the two costing methodologies. Apart from this, considering various cost pools and drivers, the manner in which Activity-Based Costing (ABC) categorizes production activities into four groups for cost allocation is also highlighted in this research report. Furthermore, the steps using which managers could calculate and assign overhead costs to each produced unit under the Activity-Based Costing (ABC) technique is also mentioned in one sub-section of this paper.
Activity-Based Costing (ABC) – The Basic Concept
Activity-Based Costing (ABC) is an accounting methodology that attempts to identify all those activities performed by every manufacturing entity and then indirect costs are assigned to produce items. This cost technique recognizes the relationship between products, underlying activities to produce them as well as their costs where indirect costs are assigned to products strategically instead of random application as done in traditional methods . Indirect costs (like office staff and management salaries are difficult to be related to a certain unit produced. Due to this reason, Activity-Based Costing (ABC) is particularly applied in the manufacturing sector.
Literature Review
Because Activity-Based Costing (ABC) improves reliability of data pertaining to the cost structure, this costing methodology tends to produce nearly accurate product costs and much better cost classification during the manufacturing process . Activity-Based Costing (ABC) is particularly used in product line profitability analysis, product costing, target costing, service pricing and customer profitability analysis. As Activity-Based Costing (ABC) results in better cost management, it helps manufacturing concerns gain much corporate focus.
Activity-Based Costing (ABC) is based on activities, which could be any unit of work, task or event, with a specific goal of either operating machines, distributing finished goods, designing products or setting up machines for production. All those activities that use overhead resources during the production processes are considered cost objects. Activity-Based Costing (ABC) considers all activities as any event or transaction that is one of the important cost drivers, activity driver or an allocation base. Examples of cost drivers include quality inspections, purchase orders, power consumed, maintenance requests, machine setups, or production orders. Activity Measures are categorized in Activity-Based Costing (ABC) as duration drivers that measure how much time a certain activity consumes to complete, and transaction drivers which involves counting the number of times an activity takes place.
The traditional cost measurement system is dependent heavily on volume count like direct labor hours and/or machine hours for allocating overhead or indirect costs to products. In contrast, the ABC costing methodology categorizes levels of activity into five broad divisions regardless of number of units produced. These five levels include product-level activity, organization-sustaining activity customer-level activity, unit-level activity, and batch-level activity.
How Activity Based Methodology System Enhances Costing Process
This system improves the cost computation and allocation process in three different ways. In the first case, the number of cost pools is expanded for assembling overhead costs. Rather than accumulating all costs in one organization-wide pool, the costs are polled and allocated on the basis of each individual activity. In the second case, this costing technique improves the costing process by creating new base to assign overhead costs to each product so that each cost is allocated based on every individual cost-generating activity rather than on volume measures like direct labor costs or machine hours. In the third case, Activity Based Costing technique modifies the nature of numerous indirect costs by categorizing them as power, inspection or depreciation expense. It also transfers overhead costs from high-volume items to low-volume items, thus increasing per unit cost of low-volume items.
Comparison of Activity Based Costing (ABC) to Traditional Cost Accounting
Manufacturing entities all across the globe employ different costing methodologies and techniques for accurately determining the cost of their products and services while generating revenue from their sales. Two most commonly used costing techniques in the business management are activity-based costing and traditional costing. Before making important discussion on these costing methods, it is imperative to remember that cost drivers are those factors that cause manufacturing entities to incur certain cost like direct material hours, direct labor hours and machine hours .
Traditional Costing Explained for Understanding
Traditional costing allocates production overhead on the basis of volume of a particular cost driver like the number of direct labor hours required in production of a certain product. Manufacturing Companies employ this costing technique for assigning production overhead costs to the number of units produced. In traditional costing method, it is assumed that manufacturing overhead cost is primarily driven or incurred on the basis of the volume metric. The users of this costing methodology, manufacturing costs are assigned only to each unit of an item. However, Traditional costing method fails to consider or include all those non-production costs that are involved in manufacturing o a certain product. The greatest example of this phenomenon is general and administrative expenses.
Traditional costing methodology was employed because no only it complies closely with Generally Accepted Accounting Principles or GAAP but can also be implemented easily for companies with only one product. Despite this, such a system has become outdated as manufacturing concerns use computerized systems and automated machines for producing multiple items with multiple production facilities. Another reason for which the traditional costing system has become obsolete is because it considers direct labor hours for calculating costs as the former is not the best cost driver. Actually, with this approach, the cost is never assigned appropriately. Traditional costing system has already been discontinued in many manufacturing concerns because it disregards non-manufacturing costs that often results in poor financial management and bad decisions.
Activity-Based Costing Explained for Understanding
This method of calculating costs tends to assign the production cost to each item on the basis of activities required to manufacture a certain unit of product. Activity-Based Costing is different from traditional system because the former calculates and assigns costs in a more accurate manner. This is so because Activity-Based Costing identifies each activity associated with the production process and assigns cost to each production activity, and then, to every produced unit accordingly .
Activity-Based Costing offers a primary benefit that it can calculate each activity’s cost with greater accuracy. In traditional costing technique, manufacturing entities calculate and assign costs only on the basis production related activities. Here, the inclusion of irrelevant or non-manufacturing costs is ignored for being allocated. Activity-Based Costing gives the internal management a better understanding as well as interpretation of overhead costs.
A Simple Illustration for Cost Allocation under Both Costing Systems
The manner in which costs are assigned to low-volume and high-volume products under traditional and activity-based costing methodologies, it is imperative that a simple illustrations should be presented for analysis and understanding. Suppose, the same manufacturing concern produces two products “124” and “366”. Item 124 is a low volume product for the production of which certain activities are required to be undertaken such many machine setups, additional testing, and special engineering since this product 124 is always ordered and manufactured in small quantities. In contrast, Product 366 is ordered and produced continuously since it tends to be a high volume item and requires no special activities as well as little attention.
If the supposed manufacturing company employs traditional costing system for cost computation and allocation, all of the overhead cost may be spread or assigned to each produced unit on the basis of the number of machine hours. Resultantly, Product 124 will be assigned little overhead cost because of fewer number of machine hours used and low amount of orders. This overhead cost allocation is regardless of whether Product 124 demanded lots of setup, testing and engineering activities. Comparatively, more amounts of overhead costs will be assigned to Product 366 due to higher number of machine hours consumed even though this item required little overhead activity. Therefore, in this particular case, the traditional costing system resulted in miscalculation of the true production overhead cost for each product.
Activity based costing has an unbound potential to deal with such a situation since it assigns overhead cost on multiple activities such as running the machine etc. In this system of cost computation and allocation, it is assumed that the machine setups, special testing, special engineering, and others are all those factors or activities that cause the company’s management to consume resources and incur costs. Under activity-based costing, whatever amount of resources was used in production and non-production activities, the company will calculate the cost and assign it to only those items the production f which required such engineering activities. In our simple illustration, any product, including item 124, that demands the performance of machine setup, special testing, and special engineering, the costs of these activities will be assigned to such products. However, since Product 366 did not demand these activities or factors, no cost will be assigned to it except for small amount of machine setup.
Steps Involved to Compute Per Unit Cost in Activity-Based Costing
As a more refined approach to compute and allocate product cost of each activity compared to the traditional costing technique, Activity-Based Costing involves the following steps:
Identify all those activities involved in the manufacturing process
Classify each activity on the basis of cost hierarchy (i.e. facility level, product level, batch-level and unit-level)
Identify and accumulate the total cost of every production activity
Determine most appropriate cost drivers involved in every activity
Calculate the total number of units of each activity’s cost driver based on its relevance
Computation of each activity’s cost per unit based on its relevant cost driver to obtain the activity rate
Apply the calculated cost of every activity to produced items on the basis of its activity usage by a certain item.
In Activity-Based Costing, it is assumed that the activities or steps that must be followed to produce an item are what helps managers arrive at incurred overhead costs. Whether fixed or variable, the overhead cost is allocated depending on every cost category known as “activity cost pools”. All those actual activities due to which the total cost in each activity cost pool increases are known as “cost drivers”. The frequency with which material inputs are ordered, the number of manufacturing lines contained by a factory, and shipments sent to the clientele are some of the prominent examples of all those activities that influence the costs incurred by the manufacturing concern. When using Activity-Based Costing, following formula is used to determine the cost per unit:
Activity-Based Costing per unit = Total Cost of an Activity / Total Number of Units for Each Activity
Computerized systems and software programs make it easier to compute costs under Activity-Based Costing regardless of whether the manufacturing concern has hundreds of activities on the production floor or they may range from five to six small activities. This could be easily illustrated with an example where a manufacturing entity, named XYZ, has determined its activity cost pools and cost drivers in the following manner:
The cost per unit is computed when the total cost of each activity cost pool is divided by the number of units of a certain cost driver. For instance, for calculating the cost per unit for the purchase department, the total cost is divided by the number of purchase orders received by purchase department. As the total cost of purchase and materials receiving department is calculated on the basis of the number of purchase orders, both the department’s cost should be added for computing “collective” per unit cost. After calculating the cost per unit for each department, all costs are added and number of items manufactured for assigning overhead costs to each unit.
Activity Categories
For assigning overhead costs to each produced item by using cost drivers, it is not necessary that the cost should be assigned to every individual unit. The overhead costs can also be computed to be assigned to a batch of the same products. Other manufacturing costs could be allocated on the basis of the number of manufacturing facilities or product lines. For assigning overhead costs in a more accurate manner, the activity-based costing methodology categorizes all production activities in the following manner:
Every time products are manufactured or services are performed, the costs are categorized on the basis of Unit‐level activities. Machine maintenance, direct materials, and direct labor are examples of unit‐level activities.
Every time some production steps are performed a batch (group) of units are manufactured, cots are divided and allocated on the basis of Batch‐level activities. Quality tests, machine setup, and purchase orders are examples of batch‐level activities.
Every activity that supports production facilities or an entire product line instead of individual units, activity-based cost is calculated and allocated based on Product‐line activities. Storage and warehousing costs for individual product lines, product design changes, as well as engineering modifications to the assembly line are the examples related to this category.
Those support activities that must take place for production and development tend to compute and assign costs based on Facility. By nature, such costs are administrative and include accounting, insurance, plant security, property taxes, building depreciation, support staff's and plant management's salaries, maintenance as well as outside landscape.
Why Companies and Organizations use Activity-Based Costing (ABC)?
Activity-Based Costing is a methodology by which costs are allocated or assigned on the basis of the number of activities and resources consumed for production of a certain product or service. It is usually applicable to those manufacturing entities which offer multiple as well as customized products and services. Companies use Activity-Based Costing requires allocation of indirect costs to each unit produced for arriving at an accurate product cost.
Though, the implementation of Activity-Based Costing is challenging, yet, it has a potential to bring improvements in business processes consider both the production and non-production costs. By doing so, Activity-Based Costing can help managers gain a clear understanding and determine non-value added activities as well as resources. By identifying and eliminating non-productive resources and activities that add up to the product cost, Activity-Based Costing can increase efficiency and profitability by implementing continuous improvement mindset in manufacturing businesses.
Not only activities and resources, Activity-Based Costing can also facilitate concerned authorities in the manufacturing entity to determine the cost pools and drivers of overhead costs. This would help determine sources of unnecessary costs and production of wasteful products, thereby, resulting in productive use of resources. Activity-Based Costing is followed by modern manufacturing concerns as it can easily help to arrive at accurate product cost instead of incorrect or excessive product pricing.
Conclusion
After carefully analyzing the information and literature review concerning Activity-Based Costing methodology, it is found that this is the most efficient technique to compute and allocate overhead costs accurately for every manufacturing concern. Unlike traditional costing method that only considers manufacturing costs, activity-based costing takes into account both the production and non-production activities for overhead cost computation. Afterwards, the collective cost, depending upon related cost pools and drivers, is assigned to each manufactured unit. With the help of a simple illustration, it is also determined that compared to traditional costing system, activity-based costing system allocates or assigns costs of extra activities only to those items that demand such factors like engineering and machine setup etc. in other words, activity-based costing technique assigns production and non-production costs only to related items or products.
Works Cited
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