Besides measuring the performance of an activity, this cost accounting technique helps to identify all the costs related to every unique activity. Activity-based costing or ABC is a costing approach for optimizing cost and time. The activity can be placed anywhere within an organizational structure, comprising of a undertaking or process.
In Activity-based costing, resource costs are assigned to activities that consume resources, and activity costs are assigned to the cost objects like services, products, and customers. ABC thus recognizes the relationship between the activities and cost drivers.
The manufacturing industry has seen a 360-degree shift in its procedures over the years. Technological innovation is at its peak, bringing in automation and many other advancements. This has also given rise to competition worldwide.
This shift has decreased the amount of direct labor required in the industry. The overhead costs are on the rise due to factors such as depreciation, maintenance, and repair works of the equipment, etc.
Since no correlation is seen between direct labor and overhead costs incurred, predetermined overhead rates based on direct labor are used, which is inappropriate. This would lead to a significant cost deviation.
This method allocates overhead costs by adopting multiple bases. It helps to prevent extra costs. Activity-based costing can help avoid this aberration.
For ABC, major activities involved have to be identified.
It can be divided into the following subcategories:
The cost of the basic materials needed is based on the volume of the output to be delivered.
The manufacturing support activities such as ordering materials and its inspection constitute the batch level activities.
Product level activities include keeping activities up to date, advertising of a product, etc.
Facility-level activities include security, maintenance, salaries, etc.
The total costs incurred for a group of activities is known as a cost pool. Costs must be assigned to the cost pools for a specified time period.
Identify the functional area cost drivers. The functional areas include materials management, standard control, R&D, marketing, etc.
Materials administration consists of issuing purchase orders and inspection of materials. The number of purchase orders placed is the cost driver for these activities.
The demand for each activity is different. The overhead costs come into the picture in this step. Assign the costs accordingly.
Activity-based costing is a cost accounting technique that identifies all the costs related to every unique activity.
ABC is an accurate costing approach which leads to better pricing decisions. This approach eliminates excess overhead costs.
Adopting ABC leads to better control over the cost of each activity, and the non-value-adding activities are identified. This also helps with the decision-making processes of the undertaking.