What Is Activity-Based Costing ABC? Explanation & Example

One of the main benefits of ABC is that it provides a more realistic picture of the cost drivers and the value of each service. This way, ABC can capture the complexity and diversity of service delivery and avoid under- or over-costing some services. This can help the firm to price its services more accurately, improve its profitability and identify areas for improvement. ABC systems require teamwork across the organization and therefore require employees to take time out from their day-to-day activities to assist in the ABC process (e.g., to identify costly activities).

A former practicing accountant and Kaplan Financial teacher, Nick currently lectures at the University of Liverpool where he specialises in management accounting and financial management. You can access the entire P2 course along with all of our other objective test and case study courses by purchasing our All Access membership. With your application and report analysis, your system can evolve, which will affect the effective tracing of more and more of your company’s activities. In terms of an implementation using an ERP, we know how expensive and complicated it is to customize these systems. In addition, their static and cumbersome nature doesn’t provide the flexibility required for an implementation of this kind.

Activity Based Costing: Everything You Need to Know about the ABC Methodology

The capacity of most resources is measured in terms of time availability, but the new ABC approach can also recognize resources whose capacity is measured in other units. For example, the capacity of a warehouse or vehicle would be measured by space provided, while memory storage would be measured by megabytes supplied. In these situations, the manager would calculate the resource cost per unit based on the appropriate capacity measure, such as cost per cubic https://www.bookstime.com/ meter or cost per megabyte. The overhead costs assigned to each activity comprise an activity cost pool. Recall from Chapter 2 “How Is Job Costing Used to Track Production Costs?” that the manufacturing overhead account is closed to cost of goods sold at the end of the period. If actual overhead costs are higher than applied overhead, the resulting underapplied overhead is closed with a debit to cost of goods sold and a credit to manufacturing overhead.

• Unfortunately, the difficulties of implementing and maintaining traditional ABC systems have prevented them from being adopted on any significant scale.
• Therefore, it acts as a tool for measuring the cost of activities and thus helps in decision-making.
• Activity-based costing (ABC) has revealed startling information in these companies.
• Using activity-based management, managers identify which activities consume resources.

When employees understand the activities they perform, they can better understand the costs involved. Some ABC systems rank activities by the degree to which they add value to the organization or its outputs. The purchase requisition note is not raised https://www.bookstime.com/articles/activity-based-costing in the purchasing department where most of the costs relating to procurement or purchase are incurred. For example, the procurement or purchase of materials is made on the basis of a requisition note sent by a manufacturing department or stores.

Managerial Accounting

This will result in little overhead cost allocated to Product 124, because it did not have many machine hours. In contrast, Product 366 will be allocated an enormous amount of overhead (due to all those machine hours), but it demanded little overhead activity. The result will be a miscalculation of each product’s true cost of manufacturing overhead. Activity based costing will overcome this shortcoming by assigning overhead on more than the one activity, running the machine.

Activity-based costing is a more specific way of allocating overhead costs based on “activities” that actually contribute to overhead costs. In job-order costing and variance analysis, overhead costs are applied based on a specific cost driver such as labor hours or machine hours. After carefully studying GAME Company, the consultant identified four unique activities. Each of these activities was a significant consumer of resources and generated substantial costs. The robotics function related to the operation of the highly automated assembly line. A large part of the cost of robotics was tied directly to the number of units produced.

Objectives of the ABC System of Costing

Using the activity-based costing approach, the defendant‘s expert formed three activity cost pools—labor, kiosk, and gas dispensing. The first two cost pools allocated costs using gallons of gas sold and therefore were allocated as they would be with the plantwide approach (63 percent for regular grade, 20 percent for plus, and 17 percent for premium). The third cost pool (gas dispensing) allocated costs equally to each grade of fuel (i.e., one-third of costs to each grade of fuel). The gas dispensing pool included costs for storage tanks, all of which were the same size, as well as gas pumps and signs.

It encourages management to evaluate the efficiency and cost-effectiveness of program activities. So, we can take that $76,000 divided by the 80,000 units that we think are going to be produced and that will give us $0.95 per unit. And now we know across the production of both product lines, we’re going to make 360 supplier orders (200 for A + 160 for B).

Activity-Based Costing vs. Full Costing

Such expansion has caused ABC systems to exceed the capacity of generic spreadsheet tools, such as Microsoft Excel, and even many ABC software packages. For example, the automated ABC model for Hendee Enterprises, a $12 million fabricator of awnings, took three days to calculate costs for its 40 departments, 150 activities, 10,000 orders, and 45,000 line items. Traditional ABC models also often fail to capture the complexity of actual operations. In addition, the order may be entered into the system either manually or electronically, and it may be either a standard or an expedited transaction. To allow for the significant variation in resources required by the different shipping arrangements, new activities must be added to the model, thereby expanding its complexity. The prerequisite for lesser cost in performing ABC is automating the data capture with an accounting extension that leads to the desired ABC model.

Managers are more likely to focus on improving efficiency in the most costly activities, thereby reducing costs. At this point, we have identified the most important and costly activities required to make products, and we have assigned overhead costs to each of these activities. The next step is to find an allocation base that drives the cost of each activity.

Identify Profitable Customers

This way the Overhead is assigned in an appropriate manner always respecting cause and effect relationships and not using “volumes” as a basic criterion for equal distribution. The idea is that activities are required to produce products—activities such as purchasing materials, setting up machinery, assembling products, and inspecting finished products. ABC systems and traditional systems often result in vastly different product costs. To use this costing system, you need to understand the process of assigning costs to activities. Activity-based costing can help you to set an accurate budget that breaks down exactly where your money is going—and which products are the most profitable. The advantage of an ABC system is the high quality of information that it produces, but this comes at the cost of using a large number of cost pools – and the more cost pools there are, the greater the cost of managing the system.