Activity-based costing is a cost accounting method designed to help businesses accurately price their products. Used in large-scale manufacturing companies, activity-based costing can also be a helpful tool for smaller manufacturers.
Overview: 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 managerial accounting, ABC calculations are frequently used in order to assign a cost to a specific task.
Unlike the traditional cost accounting method that uses a predetermined percentage of overhead, cost of goods sold, or a combination of the two, activity-based costing provides businesses with the true cost of producing specific items, which can be helpful for manufacturers who produce multiple products and need to know which products are profitable, which (if any) need to have pricing adjusted, and which products should not be produced any longer.
There are two activity-based costing formulas used, which we’ll discuss later.
How your business can benefit from activity-based costing
While larger manufacturing companies likely have more leeway when determining inventory product costs, a smaller manufacturing company that operates on a tighter budget could benefit from using activity-based costing, since accurate costing can directly affect the profitability of your business.
Here are a few other benefits:
1. More accurate product pricing
Using activity-based costing, you will be able to better price your products. While the cost of goods sold covers direct costs, what about all of the indirect costs that are involved in producing the products that you’re currently manufacturing?
By assigning a cost to every activity involved in producing each product, you will be able to avoid under-pricing or over-pricing your products.
2. Improve production
Using activity-based costing, you can see where production may get bogged down. Is a duplicate inspection process costing you time and money? Do your older machines require more setup time than the newer, streamlined machines?
Are you still purchasing materials from your regular supplier, even though their prices have increased nearly by 50% in the last few years?
These are just a few of the things that activity-based costing will clearly point out to you, allowing you to make the management decisions that can streamline operations and save money.
3. Decrease overhead
Activity-based costing doesn't just look at manufacturing costs; it also looks at indirect or fixed costs such as rent or utilities. For instance, what if your manufacturing facility is outdated and drafty?
Chances are you’ll be expending a lot of money heating the factory in the winter and cooling it in the summer.
Activity-based costing allows you to figure those costs into your final product pricing, while also allowing you to make accurate, management-level decisions, such as relocating to a newer, more energy-efficient building, or reducing production during certain months of the year.
Whether those changes are implemented or not is a management decision, but the point is that using activity-based costing, you’re actually aware of those costs, and can make an accurate, informed decision on what, if anything, you should do.
How activity-based costing works
Activity-based costing is used to assign overhead costs based on specific activities rather than using machine hours.
While not suitable for all manufacturing businesses, many larger businesses with more complicated overhead costs find using activity-based costing a more accurate way to determine the final cost of a product.
Depending on the product and current manufacturing environment, activity-based costing can result in a higher or a lower cost per unit.
There is a five-step process for using activity-based costing. This can be a simple process for small manufacturing businesses, or may require a great deal of time and research for larger manufacturers using more completed processes.
Service businesses can also use activity-based costing to determine whether the services offered are accurately priced.
1. Identify all of the activities needed to produce a product or service
The first step in using activity-based costing is to list all of the activities necessary in order 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:
- Purchasing goods and materials to be used in production
- Setting up machinery and equipment
- Running machines
- Product assembly
- Quality control
- Filling orders
- Customer service
For instance, purchasing goods would include the hours that a purchasing clerk works, the time spent on creating purchase orders, as well as materials received and stored.
It would also include the number of parts or materials that are purchased. Remember that any of the activities you identify will need to have a cost assigned.
2. Separate each activity into its own cost pool
After you’ve identified all of the activities necessary to create a finished product, you will need to determine the overhead costs that are associated with each activity.
For instance, the utility 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 for each activity identified in Step 1 in order to determine costs.
Here are some examples of some of the cost pools that would be associated with the activities listed in Step 1.
|Purchasing goods||Creating purchase orders for materialsReceiving and stocking materialsSalaries of receiving personnel|
|Running machines||Setting up machinesCost of repairing machinesRoutine maintenance of machinesInsurance costs of running machinesUtility cost of running machines|
|Filling orders||Moving products from productionCost of shipping materialsSalaries of order fulfillment personnel|
3. Assign a cost driver for each activity
Each cost pool has to have an associated cost driver. If you choose to use activity-based costing, it cannot be properly implemented without the assignment of cost drivers. For instance, a cost driver for product assembly could be the number of products assembled, the number of hours shipping and receiving clerks work, or the number of hours a machine runs.
4. Calculate predetermined overhead rates
The next step is to divide your total estimated overhead costs by the cost pool drivers that you’ve assigned. The formula for determining the cost driver rate is:
Total Cost Pool Overhead ÷ Total Cost Driver
For instance, the salary of your order fulfillment clerk is $35,000 a 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 drivers
Your order fulfillment clerk worked a total of 500 hours filling orders for a particular product. The formula for calculating overhead is:
Cost Driver Rate x Cost Driver = Overhead Cost
That means that if your clerk worked for 500 hours to fulfill orders for this product, the overhead cost 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 of heart, and if you’re just starting a manufacturing business and want to use this costing method, it is highly recommended that you consult with an experienced accountant or CPA.
Most small business accounting software applications do not offer the capability to automatically calculate product costs using the ABC method of costing. However, they are equipped to provide you with the financial information necessary in order to use this costing method for your business.