Activity-Based Costing – Definition Process and Examples

America founded the activity-based costing system between the 70s and 80s. Activity-based costing is known as ABC costing. This methodology is more popularly adhered to in manufacturing industries. This is unique as it focuses on activities. It assigns costs to various activities and not to services or products. This methodology is used in accounting because it is products that consume activities, unlike traditional cost processes. The various activities include any tasks, functions or even methods that produce visible results over a specific timeframe

In simple words, this costing focuses on the multiple types of activities that go into making products. In simple terms, this costing helps determine the costs and the pricing for production activities. This can also include employees testing a product in the automotive industry. This costing methodology helps determine all the various factors that create an activity, the respective costs associated with these activities and the relationship between the products and these activities. It assists managers with valuable details which come in handy for all costing functions.

Did you know?

Activity-based costing was discovered by Kaplan and Bruns towards the end of the 1980s and became increasingly popular across the years.

What Is Activity-Based Costing?

Manufacturing enterprises manufacture products to sell to their diverse clients. Every manufacturing organisation has to understand the costs involved in manufacturing every product they make. They can determine this through the process of product costing. They can arrive at this by including the direct costs of the labour costs involved, manufacturing and every other cost associated with creating that product. These include the rent and payroll taxes imposed on the daily wages of labour involved and the overall maintenance of the machines involved in the production.

The direct costs, in this case, would include the materials used and the labour which assists in creating the product. The indirect costs include the rent and machine maintenance costs. ABC costing allows organisations to get a deeper understanding of all the costs involved in crafting a product. This, in turn, helps organisations create a more effective strategy for pricing.

This costing methodology considers every event and transaction involved in producing a product as a cost driver, called an activity driver. Quality inspections that are conducted, the power utilised, setting up of machines, maintaining them regularly, and production and purchase orders are some examples of what constitutes a cost driver.

Also Read: What are the different types of Job Costing Concepts

What Is The Difference Between Activity-Based Costing and Traditional Costing?

There are many differences between these two types of costing methods. A little ABC analysis cost accounting will help you understand its relevance compared to traditional costing methods.

Given below are details of the same:

Some organisations refer to activity-based costing, while others prefer traditional costing. Let us understand the reasons behind this:

Why Do Some Organisations Prefer ABC Costing?

• It takes into account all the resources which are involved in creating a product.
• It considers every activity that is involved in the manufacturing of the product.
• All businesses and managers prefer complete accuracy to understand their profit margins well.
• It gives the business unit an insight into the different activities involved in the production process.
• This helps to improvise the long-term efficiency of a business.

Why Do Some Organisations Prefer Traditional Costing?

Many organisations prefer traditional costing, and the reasons are manifold.

• It applies one single cost driver for all its activities. The various overheads incurred are bifurcated as variable and fixed. Some find this easy to comprehend.
•  It is suited for external usage.
•  Organisations that experience less overhead costs prefer this. 

However, it is unable to determine distinct costs.

Benefits Of Activity-Based Costing

Some of the benefits of activity-based costing are as follows:

• It works as an effective tool for correcting incorrect cost details.
• It takes into consideration the minutest activity which is involved in the actual manufacturing of a product.
• Different products are produced differently, and the consumption of resources for each product varies.
• It details all the resources of an organisation consumed in manufacturing a product.
• It gives you an insight into the production processes and their effectiveness and allows you to make necessary corrections wherever required.
• ABC costing helps improve the decision-making processes of the management.
• It helps in the removal of all activities which do not add value to the manufacturing activity of the product range.
• It determines every cost across the manufacturing activities, which gives accurate details of the overhead costs and helps to enhance the product value.
• ABC costing helps you allocate distinct overhead costs to more expensive products, thereby streamlining the overall business processes.
• It helps you to determine your profit margins accurately. This further enables you to make appropriate changes in the prices of the range of products whenever required.

Drawbacks Of Activity-Based Costing

• It is a costly process as all details get accounted for from the start to the final manufacture of the product.
• Collecting and preparing all the data involves a lot of time and is not cost-effective.
• Though it helps to eliminate overhead costs, different products require different production timeframes and some expenses are indispensable.
• When manufacturing machines are upgraded with new technology, it will impact the costing system, which has already introduced a level of standardisation.
• You can never divide some overhead by the utility of a product, e.g., a chief executive’s monthly income.
• ABC costing methodology does not conform to the accounting principles, which are often the accepted norm by most organisations.
• There can be conflicts regarding the performance of management, especially when the organisation switches from traditional costing to ABC costing processes.
• It is not effective in manufacturing organisations that experience fewer overhead costs.

Also Read: What is Variable Cost?

Activity-Based Costing Example

• XYZ is a manufacturing company where the total number of hours spent by its labour force in work impacts its electricity bill directly. In one year, e.g. the total amount of the bill is ₹50,000.
• The total number of hours worked (taken as the cost driver) – is 2500
• The cost driver rate – is ₹50,000 divided by 2500 hours of work = ₹20
• The manufacturing company utilises electricity for 10 hours.
• The total overhead cost of the product = ₹200 (₹20 x10 hours)

Conclusion

This article helps you understand the various benefits of activity-based costing and the multiple advantages of implementing it in a manufacturing business. ABC costing helps management make practical decisions and strategise sensible pricing policies. It also helps to reject activities that add zero value to the manufacturing process of products. This, in turn, helps reduce overhead costs. This costing methodology also enables us to understand the profit margins and allows management to diversify more products. 
Follow Legal Tree for the latest updates, news blogs, and articles related to micro, small and medium businesses (MSMEs), business tips, income tax, GST, salary, and accounting.