The what and why of Activity-Based Costing (ABC)
Pricing your products optimally requires an acute and accurate understanding of your costs of production. While traditional costing methods enable firms to allocate indirect costs at a single overhead rate, this method is subpar at best. Activity-based costing (ABC) resolves this issue by precisely assigning specific indirect costs to several products produced by the company.
Activity-based costing is a cost accounting method, which apportions specific overheads to various products produced by the company.
It does this by first identifying all the activities associated with production, such as product design, setting up and operating machinery, product distribution, etc. It then computes the costs associated with these activities and assigns them to manufactured products.
There are four types of activity-based costing activities: unit-level, batch-level, product-level, and facility-level (across the organisation) activities.
The main purpose of activity-based costing is to allocate specific indirect costs to products to gain detailed insights into product costing and profitability. It enables companies to improve their cost management and pricing strategies by singling out specific activities that are raising production costs and require improvements.
Activity-based costing involves the following steps:
- Step 1: Determination of activities: The first step is to identify all the activities required for creating a certain product, including research and manufacturing facility set-up.
- Step 2: Split activities into cost pools/centres: Follow-up activity identification by tracing costs associated with each activity and dividing them into corresponding cost pools.
- Step 3: Ascribe cost drivers to the cost centres: The cost driver is the prime factor affecting an activity's cost. It is usually in the form of the number of hours or the number of units.
- Step 4: Compute the cost driver rate: To calculate the cost driver rate, divide the total activity overheads by its corresponding total cost drivers.
- Step 5: Assign costs: Finally, assign indirect costs to your product. For this, multiply the cost driver rate by the number of hours/units/parts of activities that are involved in making your product.
The formula for activity-based costing (ABC) is as follows:
ABC cost driver rate = Total cost pool overheads / Total cost drivers
ASD company desires to switch over from absorption costing to ABC costing and has identified two distinct activity cost pools: purchasing pool and assembling pool. It estimates £175,000 overheads for the ‘purchasing pool’ with the number of purchase orders (standing at 800) as the cost driver.
Furthermore, the number of assembly hours (currently at 500) is the cost driver for the ‘assembling pool’, with associated indirect costs of £80,000. Here, ABC costing will be as follows:
ABC for purchasing pool = £175,000/800 = £218.75 ABC for assembly pool = £80,000/500 = £160 Total ABC for ASD company = £218.75 + 160 = £378.75
There are numerous benefits to using activity-based costing, which we touch upon below.
- Provides accurate and realistic costs: By separating overheads into various cost pools, activity-based costing provides superior insights into cost drivers and is a better reflection of the actual costs involved in producing a product.
- Identifies cost-saving areas: By allocating costs to specific products, the ABC method flags areas where costs may be disproportionately high due to process inefficiencies. Based on these results, companies can choose to improve their operations or discontinue unprofitable products.
- Improves pricing decisions: Armed with a more accurate picture of all the costs involved in creating a product, firms can optimise their pricing methods, vastly improving their profit margins over the long term.
- Ensures better resource allocation: Activity-based costing increases the visibility of untraceable indirect costs, such as depreciation and utilities, allowing firms to precisely determine their products’ final costs. Thus, companies can make informed decisions about which activities to spend on, which activities to automate, and what products to focus on.
Activity-based costing is not without its own set of disadvantages, which we elaborate on as follows:
- Time-consuming process: As the costs are first assigned to separate cost pools and then allocated to individual products, carrying out activity-based costing can be quite time-consuming. Besides, estimating key cost drivers for cost apportionment is a complex task.
- Requires more manpower: Activity-based costing requires a dedicated team of professionals to carry out data-intensive processes of dividing and apportioning costs to cost centres and specific products, respectively. This can drive up the costs significantly and may even require the firm to outsource some of these undertakings.
- Necessitates detailed data: Activity-based costing process requires onerous amounts of data to classify activity-based overheads into cost pools. Such information may not be readily available to all firms owing to their outmoded manufacturing systems or accounting software. Besides, it may require constant maintenance and updation per evolving business exigencies.
Under traditional absorption costing, a firm aggregates indirect costs and apportions them to all products at an average single overhead rate. In contrast, activity-based costing improves upon traditional costing by accounting for the actual overheads consumed in the production process; it does so by dividing overheads into separate cost pools and ascertaining cost drivers.
Marginal costing is a method to calculate the total cost of production. It is concerned with the variable cost component, i.e., additional costs incurred for producing an extra product unit. (Contribution margin, which helps determine a firm’s profitability, is the difference between sales and this marginal cost.) Whereas, activity-based costing is a method for assigning overheads to different products per the actual usage.
Activity-based costing (ABC) provides a more accurate representation of the total activity and production costs, as it is concerned with actual consumption. It empowers firms to gain deeper insights into margins and cost savings, vastly improving pricing decisions and long-term profitability.