Activity Based Costing
Did you know that running a business takes quite a lot of costs, including overhead costs? Thanks to these added expenses, your expenditure can go quite high. You need the funds to run the operation, so it’s not possible to reduce overhead costs.
Here is where activity based costing comes into the picture to help you manage the expense. You can focus more and figure out the best amount to allocate for each business activity. The result is a better understanding of how you’re spending your money and the best cost of the resultant products or services.
Read on and learn much more about Activity Based Costing, its advantages and disadvantages, and how it benefits the business.
What Is Activity Based Costing?
In business, costs are quite crucial for the health and well-being of an enterprise. It’s why many business owners strive to understand the production cost of every product made. The minute you start to inquire about this is when you need the activity based costing system.
All the activities that are necessary to produce your final product must be accounted for. ABC gets to assign each of the undertakings a cost which makes for much better accounting. During the manufacturing process, it’s essential to figure out the path of the money.
The money gets to cover overhead costs and requires an in-depth analysis of the business to account for it. Using ABC is crucial because you consider the direct costs of production and the overhead.
In addition, you get a much clearer picture of what it takes to produce each product. Every product has a different cost which becomes abundantly clear with ABC. The minute you figure out the costs, you can price the products the best way to earn a profit.
Lastly, using ABC is necessary if you ever want to perform some cutbacks for the business. Understanding where the money is going can you see which expenses to keep and which to cut.
Requirements of Activity Based Costing
All the activities in the manufacturing process require funds to run. For every business, striving to understand the overhead costs is crucial. These activities are better understood by using transaction drivers and duration drivers.
For duration drivers, you get to measure the time it takes to complete one activity. On the other hand, transaction drivers figure out the number of times the activity takes place. It’s different from traditional cost systems.
Certain activities are vital for any company that wants to strive in the manufacturing industry. At the top of the list is figuring out the overhead costs before pricing a product. This is where Activity Based Costing comes into effect.
Activity based costing definition is pretty self-explanatory. But, it’s always better to understand what the requirements are for this process. In the end, you have a much better grasp of the costs of producing the different items.
Advantages and Disadvantages of Activity Based Costing Approach
Some of the benefits of activity based costing include:
Overhead costs can take over a budget if not properly accounted for. Activity based costing helps manufacturers have an accurate budget by outlining each necessary activity.
The activities that bring about overhead costs are important. However, it’s best to consider which ones are important and which aren’t. The best way to do so is by using ABC.
Proper Product Pricing
The minute a manufacturer understands the direct and indirect cost to manufacture a product, they can price it properly. ABC comes in handy here because it helps you consider all costs. The data that you get helps determine the best price by knowing the total cost incurred.
Overhead costs are necessary when you want to produce a certain item. However, not all of them are needed each time. The primary activity based costing uses includes seeing which activities are important and which you can do without. By cutting costs, you bring down your expenses.
Drawbacks to expect when using the ABC approach include:
When compared to traditional costing methods, the activity based costing system is complex. It calls for getting to the nitty-gritty of each activity. You must figure each one and calculate the overhead cost, which can be difficult and time-consuming.
Even after going into details about all the activities, the ABC process isn’t 100% accurate.
It takes time and money to get accurate data for activity based costing. If the main aim is to lower expenses, this becomes an issue. You need to hire someone to help you figure out the fine data, meaning you use more time and incur an extra expense.
Labor Hours Approach vs. Activity Based Costing
Costing is essential in every business. You can use the labor hours approach (traditional) or the ABC system to determine the price of each product. To do so, you need one or more cost drivers. Here is where the two approaches differ.
The labor hours approach is different in that you only require one cost driver. Often, direct labor or machine hours are the main activity in the manufacturing process. The traditional method allocates funds to this activity as the main one for the company.
However, the approach is different for ABC. You require multiple drivers for different activities, one of which is labor or machine hours.
Doing Activity Based Costing the Original Way
When you want to calculate the ABC, you need to take the sum of the pool total and divide it by the cost driver. The result is the cost driver rate you can use in the Activity Based System to get the total of direct and indirect (overhead) costs for each activity.
It’s a step-by-step process of implementing activity based costing that yields results and can be an eye-opener to a manufacturer.
The steps to take are:
1. Activity Identification
Before using ABC to understand the overhead costs, know all the indirect activities in your manufacturing process.
2. Figure Out Costs Pool
After you come up with the activities, divide them into a cost pool. In the end, you have the costs for each activity then figure out the overhead of the cost pools.
3. Assign Cost Drivers
For every cost pool that you come up with, you need to give it a cost driver. Use either units or hours for this step of the ABC process.
4. Calculate the Cost Driver Rate
The fourth step will be calculating the cost driver rate, which is done by taking the total overhead cost of each cost pool and dividing it by total cost drivers.
5. Figure Out the Cost Driver Rate
Next, figure out the cost driver rate by taking each cost pool’s overhead cost and dividing it with total cost drivers.
6. Multiply the number of cost drivers by the cost driver rate
Activity based costing example can help make the step-by-step process above much clearer. Take, for example, company ZC. It gets an electric bill of $30000 each year from the power company. Labor hours put into the manufacturing process at ZC directly relate to the cost of electricity.
Each year, there are 2000 labor hours which is the main cost driver in this example. When you figure out the cost driver rate, you take the $30000 and divide it by the 2000 labor hours. Company ZC winds up with a cost driver rate of $15 after the calculation. Therefore, to make product X, you require about 8 hours which gives an overhead cost of $120.
Concluding on Our Talk on Activity Based Costing
Activity based costing is quite different from the traditional approach to figuring out the price of a product. It means going into detail about each activity and how much it costs the company to perform. Such accurate data makes the company run much more efficiently.
However, it’s not all roses, as it takes time and effort to be that detailed and accountable. You have to dig deep to determine all the information, but you might still not have 100% accurate information.
Still, it’s a worthwhile costing approach to use for a manufacturer who wants a better understanding of the enterprise. Plus, you can figure out in detail where to cut costs.