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

Activity- Based Costing is a costing system that focuses on the activities conducted in producing the products. It is the system in which the cost of various production activities is identified, and the final cost is added to the product.

The idea behind this costing system is that activities incur costs at every stage for the production of any product, so it is logical to do an accounting of incurred costs based on activities.

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

In the traditional absorption costing system, costs are traced to the organizational units, like any department, and then the cost incurred is traced to the final product. While in the ABC system of costing, the cost is first assigned to the activities and then passed on to the product. The important and common fact about both costing systems is that the cost is assigned to the product at the second or final stage.

Activity-Based Costing: Meaning

Activity-Based costing is allocating costs to the activities involved in the production. It can be defined as a system of costing that recognizes activities involved in producing a product and then traces the cost incurred in performing each activity.

As per the Chartered Institute of Management Accountants (CIMA), the ABC has been defined as: "ABC is the cost attribution to cost units based on benefits received from indirect activities, e.g., ordering, setting up, assuring quality, etc."

From the above definition, ABC is the costing system in which cost is attributed to each activity, and then it is summed up to the product.

Features of ABC

  1. ABC costing system consists of two stages of the cost of the product. In the first stage, the cost is assigned to the production activities, and then in the final stage, the cost is allocated to the final product.
  2. It follows the approach of accumulated activity-related costing.
  3. The activity considered for estimation of cost should be any task undertaken for the production of any product or for delivering any services.
  4. ABC system follows the concept that the products consume activities, and the activities consume resources.
  5. ABC costing method can be used by any manufacturing or service delivery firm that wants to ease cost accounting.

Objectives of the ABC System of Costing

  1. To effectively estimate the cost of the product or the services.
  2. Identifying which activities are value-adding and non-value-adding in the production process can help eliminate unnecessary activities.
  3. To provide correct and accurate information for decision-making.
  4. To identify high-cost activities and take proper action to reduce costs.
  5. To identify non-essential activities involved in the production of goods and services.
  6. It can help to motivate managers through the evaluation of the efficiency of activities in production.

Difference between the Traditional Absorption Costing Method and the Activity-Based Costing Method

Activity-Based Costing (ABC): Method and Advantages Defined with Example
Traditional Absorption Costing Activity-Based Costing
In this, the overhead expenses are first allocated to departments or units. In this system, the overhead expenses are assigned to production activities or passed to cost pools.
It consists of only two types of activities; they are Unit level activities and Facility level activities. Here the cost is assigned to all the activities included under the manufacturing hierarchy, like Unit level, batch level, product level, and facility level.
In this system, the cost is allocated to the cost centres or locations where costs are incurred. In this system, the costs are assigned to the production activity factors.
Here only the cost of production of products can be ascertained. In this system, apart from the cost of the product, other objects or activities involved in the production process can be ascertained, like costs incurred under customer segments, distribution, packaging, etc.

What are the steps involved in setting up the Activity- Based costing?

In developing the ABC method of cost, several steps are needed to be followed:

1) Identifying Resources

Identifying resources means finding out the possible expenditure of the organization, which is to be assigned to the cost of the product. So, resources mean expenses that are to be incurred at each activity, which will be allocated first to the activity, and then to the product.

2) Identification of Activities

The method of ABC costing is based on the activities performed during the production of the product or delivery of the services. Therefore, it is very necessary to point out the activities associated with the production of the product to allocate the incurred expenses. In this step, activities are identified for the allocation of cost.

3) Identification of Cost Drivers

The identification of cost components is the cost drivers involved in different activities. Cost drivers or cost objects are the factors that impact the cost of a particular activity. It is very important to find out the things that determine the cost of an activity.

4) Assigning Cost to the Product

The final step is assigning the cost to the product after tracing all the incurred costs to the product.

What is the importance of the ABC method of cost?

  • ABC costing method is important to bridge the cost to its cost drivers.
  • This method allows us to determine the cost of the activities involved rather than the centre of the cost.
  • It helps to assign the cost with greater effectiveness due to the cost related to its activities.
  • It eliminates the blanket expenses used in the traditional absorption method of costing.
  • ABC method effectively reduces and controls costs due to the effective identification and allocation of overheads.
  • It presents the cost associated with the product in the most accurate form.

Uses of Activity-Based Costing Method

The information gained from the ABC method of costing is useful in different areas of decision-making, which are discussed below:

1) Activity Cost

The motive of the ABC method of costing is to allocate the overheads involved in the activity. This helps us track whether the cost of the activities is in line with the industry's standards. Therefore, it acts as a tool for measuring the cost of activities and thus helps in decision-making.

2) Customer Profitability

The company has to bear various customer costs apart from the cost of product production, like consumer services, return product handling, cooperative marketing, etc. The ABC costing system can help sort this additional cost and help the management identify profitable customers.

3) Distribution Cost

Efficient distribution of products to consumers is a major task for any entity. Organizations use distribution channels like retail, e-commerce, wholesalers and distributors, etc. In the distribution of products through any of these channels, an overhead is involved in maintaining the channel. So, with the help of ABC, the company can determine which form of distribution channel and how much it costs, and on that, decisions can be made to determine which type of channel is profitable and which is not.

4) Domestic or Outsource

The ABC provides information about the cost incurred on each production activity; with that help, the management can decide which activity is profitable to perform domestically and which is required to be outsourced. Management can outsource any activity if that incurs a higher cost domestically than outsourcing.

5) Determination of Margins

For any business, the margin is a very important component as it is the profit earned after selling the product. By properly allocating overheads under the ABC costing method, management can determine the maximum desired margin of the product. It also helps position the company's resources to earn the highest margins.

6) Minimum Price Fixation

Product pricing is the price the market can bear, and the manager's motive should be to avoid selling the product below the minimum profitable price. Therefore, the ABC costing method helps the management to determine which activity cost to be included in the minimum cost of the product so that the product can be delivered profitably.

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