Activity-based costing (ABC)
Activity-based costing is a more precise method of distributing the overhead cost based on the "activities" that really contribute to overhead costs. The application of overhead costs is based on a particular cost driver, such as labour hours or machine hours, in job-order costing and variance analysis. In contrast with standard costing techniques, this accounting method of costing recognises the connection between costs, overhead activities, and produced goods, allocating indirect costs to products less randomly. However, some indirect expenditures, such as the salary of the management and office personnel, are challenging to relate to a specific product.
A method of assigning overhead costs based on "activities" is activity-based costing. This sets it apart from job-order costing, which distributes costs based on a particular cost driver, such as machine hours.
Instead of just focusing on one variable (such as labour hours or machine hours), activity-based costing takes into account all potential cost-generating activities.
The amount of overhead and indirect costs associated with a certain activity is determined using the cost driver rate, which is the cost pool total divided by the cost driver.
Using activity-based costing (ABC), overhead and indirect costs—like wages and utilities—are allocated to specific goods and services.
It doesn't matter whether designing items, assembling machines, running machines, or distributing products—any operation has a definite goal.
The ABC method of cost accounting is built on activities, which are defined as any occasion, project, or job with a clear objective.
Activity-based costing should not be treated as an alternative to job costing or process costing but as one of the best tools for refining a costing system which provides a better measurement of the non-uniformity in the use of an organization’s overhead resources for job, products and services.
Cost Object: It indicates an item for which cost is calculated using the Activity-based costing System. For Example, a service, a customer or a product.
Cost Driver: A cost driver is any factor or force that causes a change in the cost of an activity.
Example of cost driver and cost object
Cost function cost driver
Production Number of units/number of set up
Marketing Number of order/number of sales staff
Research and development Number of research staff / technical complexities/number of hours spend
Customer Number of service call / number of produced service
By the application of cost pool analysis, the cost manager can identify the following cost drivers for example:
Number of hours of maintenance
Machine hours
Labour hours
Number of units produced
Factory square foot area utilized.
Example :
XYZ Ltd. produces three products ‘P’, ‘Q’ and ‘R’ for which the standard costs and quantities per unit are as follows:
Product P Q R
Output(unit) 5000 15000 22000
Direct Material (£) 100 80 60
Direct Wages (£) 60 80 100
Labour hour (per unit) 3 4 5
Machine hour (per unit) 4 4 7
No of purchase order 600 900 1000
No. of set-ups 140 110 150
Production overhead split by departments:
Department A (£) 550,000
Department B 750,000
130,000
Department ‘A’ is labour intensive while Department ‘B’ is machine intensive. Total labour hours in Department A = 55,000 Total machine hours in Department B = 1,50,000 Production overhead split by activity:
Receiving / Inspection (£) 700,000
Production / Machine setup 600,000
130,000
no.of batches received/ inspected 2500
no.of production/ machine setup 400
Prepare Product Cost Statement under traditional Absorption Costing and Activity-based Costing Methods.
Overhead Absorption Rates (OAR): Department ‘A’ = £5,50,000 ÷ 55,000 Labor hours = £10 per labour hour.
Overhead Absorption Rates (OAR)Department ‘B’ = £7,50,000 ÷ 1,50,000 Machine Hours = £5 per machine hour.
Product P Q R
Direct material 100 80 60
Direct wages 60 80 100
Production overhead
Department A (Labour hour X OAR) 30 40 50
Department B (Machine hour X OAR) 20 20 35
Total cost per unit 210 220 245
Calculation of Cost Driver Rates:
(i). Receiving/Inspecting = Overhead ÷ No. of batches received/inspected
= £7,00,000 ÷ 2,500= 280 per requisition.
(ii). Production Scheduling/Machine Sets-up = Overhead ÷ No. of batches for scheduling
= £6,00,000 ÷ 400 = 1,500 per set-up
Calculation of Overhead per unit
Receiving / purchase: cost per order X no. of order ÷ total output
P = (£280 x 600) / 5,000 = £33.60
Q = (280 x 900) / 15,000 = 16.80
R = (280 x 1,000) / 22,500 = 12.44
Production / set-up : cost per setup X no. of setup ÷ total output
P = (£1,500 x 140) ÷ 5,000 = £42.00 Product
Q = (1,500 x 110) ÷ 15,000 = 11.00 Product
R = (1,500 x 150) ÷ 22,500 = 10.00
Product P Q R
Direct material 100 80 60
Direct wages 60 80 100
Production overhead
Receiving/inspection 33.60 16.80 12.44
Production/machine set-up 42 11 10
Total cost per unit 235.60 187.80 182.44
Comparison of Absorption and activity-based costing.
Under the absorption costing method, Product ‘R’ is more expensive while under the activity-based costing method, product ‘P’ is more expensive.