A beginner’s guide to activity-based costing
Activity costing is a method used to more accurately track the true cost of producing a product or service. Learn more about this costing method and see if it’s right for your business.
Activity-based costing is a cost accounting method designed to help companies price their products accurately. Used in large manufacturing companies, activity-based costing can also be a useful tool for small manufacturers.
Presentation: what is activity-based costing?
Activity-Based Costing (ABC) is a method that can be used to assign a specific cost to products and services. Used in management accounting, ABC calculations are frequently used to assign a cost to a specific task.
Unlike the traditional method of cost accounting which uses a pre-determined percentage of overhead, cost of goods sold, or a combination of the two, activity-based costing provides businesses with the actual cost of producing specific items, which can be useful for manufacturers who produce multiple products and need to know which products are profitable, which (if any) need price adjustment and which products should no longer be produced.
Two activity-based costing formulas are used, which we will discuss later.
How your business can benefit from activity-based costing
While larger manufacturing companies likely have more leeway in determining the costs of in-stock products, a small manufacturing company operating on a tighter budget could benefit from using activity-based costing, as accurate costing can directly affect the profitability of your business.
Here are some other benefits:
1. More accurate product pricing
By using activity costing, you will be able to better evaluate your products. While cost of goods sold covers direct costs, what about all the indirect costs involved in producing the products you currently make?
By assigning a cost to each activity involved in the production of each product, you can avoid undervaluing or overvaluing your products.
2. Improve production
By using activity-based costing, you can see where production may be getting bogged down. Is a duplicate inspection process costing you time and money? Do your older machines require more setup time than newer, streamlined machines?
Do you still buy materials from your usual supplier, even though their prices have increased by almost 50% in the last few years?
These are just a few of the things activity-based costing will make clear to you, allowing you to make the management decisions that can streamline operations and save money.
3. Reduce overhead
Activity costing is not limited to manufacturing costs; it also looks at indirect or fixed costs such as rent or utilities. For example, what if your manufacturing facility is outdated and drafty?
Chances are you will spend a lot of money heating the plant in the winter and cooling it in the summer.
Activity-based costing allows you to incorporate these costs into the price of your final product, while allowing you to make specific management decisions, such as moving to a newer, more energy-efficient building. energy, or the reduction of production during certain months of the year.
Whether or not these changes are implemented is a management decision, but the fact is that by using activity-based costing you are actually aware of these costs and can make an accurate and informed decision about what you should do. , if applicable.
How activity-based costing works
Activity-based costing is used to allocate overhead based on specific activities rather than using machine hours.
Although not suitable for all manufacturing companies, many large companies with more complex overheads find that using costing by activity is a more accurate way to determine the final cost of a product.
Depending on the product and the current manufacturing environment, costing by activity may result in a higher or lower unit cost.
There is a five-step process for using activity-based costing. This can be a simple process for small manufacturing companies, or can be time-consuming and research-intensive for larger manufacturers using more comprehensive processes.
Service companies can also use activity-based costing to determine if the services offered are priced accurately.
1. Identify all the activities necessary to produce a product or service
The first step in using activity-based costing is to list all the activities needed to create your product. Be sure to include both direct expenses such as materials, as well as indirect expenses such as utilities and rent. Here are some examples of activities to include:
- Purchase of goods and materials for use in production
- Installation of machinery and equipment
- Product assembly
- Quality control
- Fill orders
- Customer service
For example, the purchase of goods would include the hours worked by a purchasing clerk, time spent creating purchase orders, and materials received and stored.
This would also include the number of parts or materials purchased. Remember that any activities you identify will need to have an assigned cost.
2. Separate each activity into its own cost pool
After you have identified all of the activities required to create a finished product, you will need to determine the overhead associated with each activity.
For example, the cost of running production machines would be included in the running machines cost pool. In order to use activity-based costing correctly, you will need to calculate the cost of each activity identified in Step 1 to determine costs.
Here are some examples of cost groups that would be associated with the activities listed in Step 1.
Purchase of goods
Create purchase orders for materialsReceiving and storing materialsReceiving staff salaries
Installation of machinesCost of repairing machinesRoutine maintenance of machinesInsurance costs of running machinesUtility cost of running machines
Moving products from production Cost of shipping materials Salaries of order fulfillment staff
3. Assign a cost driver for each activity
Each cost group must have an associated cost driver. If you choose to use activity-based costing, it cannot be properly implemented without assigning cost drivers. For example, a cost driver for product assembly could be the number of products assembled, the number of hours a shipping and receiving clerk works, or the number of hours a machine runs. .
4. Calculate Predetermined Overhead
The next step is to divide your total estimated overhead costs by the cost group drivers you assigned. The formula for determining the cost driver rate is as follows:
Total Cost Group Overhead ÷ Total Cost Driver
For example, your fulfillment clerk’s salary is $35,000 per year and your clerk worked a total of 1,500 hours during the year. The formula for determining the overhead rate for direct labor is to divide the clerk’s salary by the number of hours worked:
$35,000 ÷ 1,500 = $23.33
5. Calculate overhead based on cost factors
Your fulfillment clerk worked a total of 500 hours to fill orders for a particular product. The formula for calculating overhead is as follows:
Cost Driver Rate x Cost Driver = Overhead
This means that if your clerk worked 500 hours to fulfill orders for this product, the overhead would be $11,665.
500 x 23.33 = $11,665
Using the ABC allocation rate formula, you can now allocate this amount to the final cost of producing the product.
Activity-based costing is complicated
Activity-Based Costing or ABC Accounting is not for the faint-hearted, and if you have just started a manufacturing business and want to use this method of costing, it is highly recommended that you consult an accountant or Experienced CPA.
Most small business accounting software applications do not provide the ability to automatically calculate product costs using the ABC costing method. However, they are equipped to provide you with the necessary financial information to use this costing method for your business.