What is Activity Based Costing?
Activity based costing (also known as ABC costing) refers to the allocation of cost (charges and expenses) to different heads or activities or divisions according to their actual use or on account of some basis for allocation i.e. (cost driver rate which is calculated by total cost divided by total no. of activities) to arrive at a profit.
Examples include square footage that is used per product, and the same would be used to allocate the rent of the factory as well as the maintenance cost of the firm; similarly, the number of purchase orders (i.e., PO) used to allocate the purchasing expenses of the purchasing department.
Activity Based Costing Formula
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For eg:
Source: Activity Based Costing (wallstreetmojo.com)
The ABC formula can be explained with the following core concepts.
- Cost Pool: This is an item for which measurement of the cost would require, e.g., a product
- Cost Driver: It is a factor that will cause a change in the cost of that activity. There are two kinds of cost driver:
- 1) Resource Cost Driver: It is a measure of the number of resources that shall be consumed by an activity. This will be used to assign the cost of a resource to an activity. E.g., Electricity, Staff wages, Advertising, etc.
- 2) Activity Cost Driver: This is the measure of the intensity of demand and the frequency that is placed on the activities by the cost poolsThe Cost PoolsA cost pool is a strategy to identify the company's individual departments or service sector costs incurred. It determines the total expenses incurred in manufacturing goods and allocates them to different departments or service sectors based on valid identifiers known as cost drivers.read more. It will be used to assign the activity costs to a product or a customer. E.g., Material ordering costs, Machine set up costs, Inspection and testing charges, Material handling and storing costs, etc.
Examples of Activity Based Costing
Let’s see some simple to advanced examples to understand it better.
Example # 1
BAC ltd is considering shifting from the traditional costing method to ABC based costing method, and it has got the following details. Using ABC costing formula, find out the new overhead rates for the company.
We have here given two activities. The first one is a machine set-up activity, and the second one is inspecting the same. So the drivers areas the number of machine setup would increase the cost would also increase, and similarly as the number of inspecting hours increases, that would lead to an increase in inspection cost as well. Hence, we need to allocate those costs based upon their cost driversCost DriversA cost driver is a unit that derives the expenses and sets a basis on which a particular cost is to be allocated between the different departments and on the basis of that driver’s activity completed in that particular period the cost is allocated. These are the structural determinants of the activities on which cost is being incurred and determine the behavior of the costs on an activity.read more.
Using the ABC formula: Cost Pool total / Cost driver
Calculation of Machine Setup Cost
Machine setup cost / Number of Machine setups
=2,00,000 / 340
Machine Setup Cost = 588.24
Calculation of Inspection Cost
Inspection cost /Inspection hours
=1,40,000 / 7500
Inspection Cost= 18.67
Example # 2
The following details pertain to different activities and their costs for Gamma Ltd. You are required to calculate the overhead rate for each activity.
Below is given data for calculation.
We are here given five activities; hence, we need to allocate those costs based upon their cost drivers.
Using the ABC formula: Cost Pool total / Cost driver
Each activity pool’s total cost is divided by its cost driver to arrive at different rates.
Overhead Rate for the Purchasing Activity
Overhead Rate for the Purchasing Activity = 1,20,000 / 200
Activity-Based Costing for Purchasing will be –
Overhead Rate for the Purchasing Activity =600.00
Similarly, do the calculation of ABC Cost Formula for all the cost pool activities
Total Estimated Overhead = 862500.00
Example # 3
Mamata Inc., a manufacturing company of drugs, is considering switching from their traditional method of cost to a newly implemented system by their production head. It is activity-based costing so that the two products Z serum and W serum can be sold at their proper cost and make them price competitive in the market.
Below are the production details that have been derived from the production sheet.
You are required to arrive at product-based total cost using ABC formula.
We are here given six activities; hence, we need to allocate those costs based upon their cost drivers.
Using the ABC formula: Cost Pool total / Cost driver
Each activity pool’s total cost is divided by its cost driver to arrive at different rates.
Overhead Rate for the Purchasing Activity
Overhead Rate for the Purchasing Activity = 60000/1000
For Purchasing, it will be –
Overhead Rate for the Purchasing Activity = 60.00
Similarly, do the calculation of ABC Cost Formula for all the cost pool activities
And the total estimated overhead is 506250.00
After arriving at different rates, we now have to arrive at product level total cost, which would be nothing but multiplying different overhead rates as arrived above with their actual cost drivers.
Relevance and Uses
It is a type of cost allocation processCost Allocation ProcessCost Allocation is the procedure of recognizing & assigning costs to different cost objects like a product, department, program, customer, etc., as per the cost driver serving as the base for this process. read more where it identifies all kinds of company’s costs and allocates them to the costs to the products based on actual consumption.
It will enhance the process of cost in 3 different ways. First, it will expand the number of cost pools, which can later be used to assign those overhead costs. So, it pools costs by activity instead of accumulating these costs in one organization-wide pool. Second, instead of on volume measures like direct labor costsDirect Labor CostsDirect labor costs refer to the total cost incurred by the company for paying the wages and other benefits to its employees against the task performed by them, which are straight away related to the manufacturing of the products or provision of the services.read more or machine hours, it will create new bases to assign these overhead costs to items upon these activities, which shall generate costs. Lastly, it makes cost traceable to these activities.
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