Activity-Based Costing (ABC)

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What is cost-per-activity (ABC) calculation?

Costing by Activity (ABC) is a costing method that allocates overhead and indirect costs to related products and services. This cost accounting method recognizes the relationship between costs, overhead, and manufactured goods, by allocating indirect costs to products in a less arbitrary fashion than traditional costing methods. However, some indirect costs, such as the salaries of managers and office staff, are difficult to assign to a product.

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Calculation of costs by activity (ABC)

How activity costing (ABC) works

Cost-per-activity (ABC) calculation is mainly used in the manufacturing industry as it improves the reliability of cost data, thus producing almost real costs and better classifying the costs incurred by the company during its manufacturing process. production.

Key points to remember

  • Calculation of costs by activity (ABC) is a method of allocating general and indirect costs, such as salaries and utilities, to products and services.
  • The ABC cost accounting system is based on activities, which are considered to be any event, work unit or task with a specific objective.
  • An activity is a cost driver, such as purchase orders or machine configurations.
  • The cost driver rate, which is the total of the cost pool divided by the cost driver, is used to calculate the amount of overhead and indirect costs associated with a particular activity.

ABC is used to better understand costs, allowing companies to form a more appropriate pricing strategy.

This valuation system is used in target pricing, product valuation, analysis of the profitability of product ranges, analysis of customer profitability and pricing of services. Activity-based costs are used to better understand costs, allowing companies to form a more appropriate pricing strategy.

The cost per activity formula is the total cost pool divided by the cost driver, which gives the cost driver rate. The cost driver rate is used in the calculation of costs by activity to calculate the amount of overhead and indirect costs related to a particular activity.

The ABC calculation is as follows:

  1. Identify all the activities required to create the product.
  2. Divide the activities into cost pools, which include all of the individual costs associated with an activity, such as manufacturing. Calculate the total overhead for each cost pool.
  3. Assign each cost driver activity cost driver, such as hours or units.
  4. Calculate the cost driver rate by dividing the total overhead costs in each cost pool by the total cost drivers.
  5. Divide the total overhead for each cost pool by the total cost drivers to get the cost driver rate.
  6. Multiply the rate of cost drivers by the number of cost drivers.

As an example of cost per activity, consider ABC, which has an electricity bill of $ 50,000 per year. The number of working hours has a direct impact on the electricity bill. 2,500 hours of work were worked for the year, which in this example is the cost factor. The cost conductor cost is calculated by dividing the electricity bill of $ 50,000 per year by 2,500 hours, which gives a cost conductor rate of $ 20. For the XYZ product, the company uses electricity for 10 hours. The overhead for the product is $ 200, or $ 20 times 10.

Activity-based costing benefits the costing process by increasing the number of cost pools that can be used to analyze overhead costs and making indirect costs traceable to certain activities.

Cost-per-activity (ABC) requirements

The ABC system of cost accounting is based on activities, which are events, work units or tasks with a specific objective, such as the installation of machines for production, product design, distribution of finished products or the use of machinery. Activities consume overhead and are considered cost items.

Under the ABC system, an activity can also be considered as any transaction or event that is a cost factor. A cost driver, also called an activity driver, is used to refer to an allocation basis. Examples of cost factors include machine configurations, maintenance requests, power consumption, purchase orders, quality inspections or production orders.

There are two categories of activity metrics: transaction engines, which count the number of times an activity occurs, and duration engines, which measure the time it takes to complete an activity.

Unlike traditional cost measurement systems that depend on the number of volumes, such as machine hours and / or direct labor hours to allocate indirect costs or overheads to products, the ABC system classifies five broad levels of activity which, to some extent, is not related to how many units are produced. These levels include activity at the batch level, activity at the unit level, activity at the customer level, organizational maintenance activity, and activity at the product level.

Benefits of Activity Based Costing (ABC)

Costing by Activity (ABC) improves the costing process in three ways. First, it increases the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in a company-wide pool, it aggregates costs by activity.

Second, it creates new bases for allocating overhead costs to items so that costs are allocated based on activities that generate costs rather than volume measures, such as machine hours or direct costs labor.

Finally, ABC changes the nature of several indirect costs, making costs previously considered indirect – such as depreciation, utilities, or wages – attributable to certain activities. Alternatively, ABC shifts the overhead from high volume products to low volume products, thereby increasing the unit cost of low volume products.

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