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Businesses that sell goods and services have a critical need to know their costs for producing and delivering products, accurately. Accurate costing at the individual product level is essential for knowing which products are earning profits and which are selling at a loss. This information can also be crucial for pricing, production planning, and product protfolio management. Tracking product costs is a task for the firm's cost accounts, most of whom rely on traditional
costing methods. Cost accountants know, however, that these methods sometimes deliver misleading information about individual product costs. In cases where the company has reason to question the accuracy of product cost figures, many firms turn to an alternative costing method: Activity-based costing. Activity-Based Costing is a methodology for assigning costs to
individual products, services, projects, tasks, or acquisitions, based on… By measuring activities and resources consumed by individual products, ABC methods essentially convert the so-called indirect costs of traditional costing methods into direct costs. ABC contrasts with traditional costing
(cost accounting), which sometimes assigns costs using somewhat arbitrary allocation percentages for overhead or the so-called indirect costs. As a result, ABC and traditional cost accounting can estimate the cost of goods sold and gross margin very differently for individual products. Contradictory and uncertain cost estimates can be a problem when
management needs to know precisely which products are profitable and which are selling at a loss. The move from traditional costing to ABC is usually driven by a desire to understand the "true costs" of individual products and services more accurately. Companies implement Activity Based costing to: Firms that use ABC consistently to pursue these objectives are practicing Activity Based management ABM. Note that the purpose of ABC is to provide information for decision support and planning. ABC by itself usually has little or no impact on the structure of the firm's
financial accounting reports (Income statement, Balance sheet, or Cash flow statement). This impact is minimal because both ABC and traditional costing ultimately assign costs to the same existing accounts. The two approaches merely use different mathematics to do so. Note especially, however, that ABC sometimes brings improvements in reported margins and profitability. These outcomes follow when ABC reveals unnecessary or inflated costs, or when ABC shows where to adjust pricing
models, workflow process, or the product mix. This article further defines, describes, and illustrates Activity Based costing using example calculations to contrast ABC with traditional cost accounting. Examples appear in context with related terms from the fields of budgeting, cost accounting, and financial accounting. The desire to improve costing accuracy moves business people to adopt ABC, mainly to get closer to the true cost and true profitability of individual products and services. They move to Activity Based costing for the same reasons to understand better the true costs and return on investment from projects, programs, or other
initiatives. ABC pursues these objectives primarily by making direct costs out of many of the expenses that traditional cost accounting treats as indirect costs. Examples below show how ABC does this. Organizations that use ABC consistently and effectively are said to practice Activity Based management (ABM). Here, managers turn to ABC to support decisions about
pricing, adding or deleting items from the product portfolio, choosing between outsourcing and in-house production, and evaluating process improvement initiatives. For more on ABM, see the section below, "What is Activity Based management?" The
percentage of organizations currently using Activity Based costing varies significantly from industry to industry. Various surveys in the period 2012-2018 report the highest rate of firms using ABC in manufacturing (20%-50%), followed by financial services (15-25%), public sector (12-18%), and communications (6-12%). The different approaches and outcomes from ABC and traditional costing are most accessible for illustration in the context of a product manufacturing example. However, the principles appearing here extend readily to a wide range of other business settings. For example, consider a firm that manufactures automobile parts through a sequence of machine operations on metal stock. In such
settings, traditional cost accounting views "product production costs" as either direct costs or indirect costs (or overhead). Traditionally, direct costs for such firms are costs they can assign to specific product units. In product manufacturing, these might include direct materials and direct labor costs: Traditionally, indirect costs for such firms are manufacturing overhead expenses they cannot assign directly to specific product units. Instead, they allocate these costs to specific production
runs, batches, or periods. These might include indirect costs such as the following: For this example, consider a firm that manufactures and sells two product models, Model A and Model B. Some aspects of A and B compare as Table 1 shows: Management must estimate the profitability of each product to decide which products to produce and sell and how to price them. These estimates, in turn, require an understanding of the full cost per unit of each product. While the direct costs per unit are easy to find, the indirect costs are
less noticeable. As a result, the firm will have to uncover indirect product costs through a costing methodology—either traditional cost allocation or Activity Based costing. Direct costs are the same under both traditional costing and ABC. For direct costs, accountants measure a product unit cost for each direct cost category. The two costing methods differ, however, in the way they assign values to so-called indirect costs for products. Consequently, the two costing approaches
sometimes give entirely different pictures of the profitability of individual products. Cost accountants can apply traditional costing methods to find total production costs for Products A and B in Table 1 above. In one accounting period, the firm produces and sells To find product gross profits and profit margins, however, accountants will use
traditional costing methods to estimate total production costs per unit, and with that, gross profit margin per unit. For this example, product manufacturing direct costs consist of direct labor costs and direct materials cost. The firm's accounting system carries general ledger T-accounts for each product's direct labor costs. For
one accounting period, these costs are: Product A direct labor: $450,000 The accounting system also carries accounts for each product's direct materials costs. The ledger shows these direct materials costs for the period: Product A direct materials: $675,000 Product B direct materials:
$1,050,000 The Manufacturing organization provides product unit counts. For the current period: Product A: 900,000 units Product B 2,100,000 units Product A Direct labor per unit: $450,000 / 900,000 = $0.50 / unit Product A direct materials per unit $675,000 / 900,000 = $0.75 / unit The final step in finding product direct costs, Step 3, is simply adding individual product direct labor cost to the individual product direct materials cost. These figures are the results of Step 2, above. Product A Direct costs per unit calculate as $0.70 + $0.50 = $1.25 / unit Table 2 below shows the resulting direct costs for these sales, along with the given per unit sales revenues: The company's cost accountants will also find cost totals for the period's production support activities. In traditional cost accounting, these costs are known as overhead or indirect costs, as Table 3 shows. The simple form of
traditional cost accounting appearing here uses only the Total Indirect cost line from Table 3. Traditionally, firms allocate this cost total to each product, A or B, based on proportional usage of a given resource. The resource chosen for this purpose is usually one of the direct cost items. Note especially that this approach is also called production volume-based (PVB) cost allocation, for obvious reasons. Indirect Components Under PVB cost allocation, accountants allocate (apportion) the total indirect cost to Products A and B based on factors such as the proportion of the total: Other factors may also apply. For this example, the firm's accountants chose to allocate indirect costs referring to direct labor
costs. The indirect cost total from Table 3 above is $1,422,500. The direct labor total (line 6 from Table 1) is $1,500,000. From these figures, the firm allocates indirect labor cost to each product as a percentage of the product's own direct labor cost: Step 4A. Find Total Indirect Labor Costs as Percentage of Total Direct LaborIndirect labor cost / direct labor cost ratio:
Table 4, below, shows how this allocation produces indirect cost estimates per unit. And, the table also shows the conventional costing solutions for gross profit and gross margin for each product unit. Step 4B. Find Indirect Cost Per UnitEstimated Indirect cost per unit is the same for both products, $0.47 (Table 4, line 14). These two indirect costs must be equal because both products use the same allocation rate (94.8%) applied to direct labor costs, based on the same direct labor rate ($0.50/unit).
Traditional Costing Step 5. Find Product Cost Per Unit and Gross Margin Per UnitTo find product gross margins for Products A and B, the analyst calculates as line 16 of Table 4 above shows. The result is that traditional cost accounting shows:
On a per-unit basis, this traditional costing finds Product A more profitable than product B. These Product profitability results are directly comparable with the profitabilities for products A and B found in Step 6 of the Activity Based costing example below. How to Apply Activity Based Costing Direct, Indirect Costs Calculate in 6 StepsThis section presents an ABC version of the same product costing situation presented above as Traditional Costing. The examples show how ABC and traditional costing can yield different indirect cost estimates for the same products. This means the two approaches can also estimate product-specific profitability differently. Finally, the examples show that ABC requires more data and a more detailed analysis than the traditional PVB allocation approach. Activity Based Costing Step 1. Find Total Direct CostsABC costing for products A and B begins with the starting data appearing above for the traditional costing example. Data for starting the ABC analysis include:
The ABC example, therefore, begins with Table 5 (an exact copy of Table 2 above).
In this ABC example, as well, Product manufacturing direct costs consist of direct labor costs and direct materials cost. ABC Step 1A. Find Total Direct Labor Cost for Each ProductFrom the firm's general ledger accounts, these costs for the period are: Product A direct labor: $450,000 Product B direct labor: $1,050,000 ABC Step 1B Find Total Direct Materials Cost for Each Product.The ledger shows these direct materials costs for the period: Product A direct labor: $675,000 Product B direct labor: $1,050,000 Activity Based Costing Step 2. Find Direct Labor and Materials Costs per UnitThe Manufacturing organization provides these product unit counts for the period: Product A: 900,000 units Product B 2,100,000 units ABC Step 2A. Find Each Product's Direct Labor Cost per UnitProduct A Direct labor per unit: $450,000 / 900,000 = $0.50 / unit ABC Step 2B Find Each Product's Direct Materials Cost per UnitProduct A direct materials per unit $675,000 / 900,000 = $0.75 / unit Activity Based Costing Step 3. Find Total Direct Cost for Each Product UnitLabor for final assembly and test of each unit is direct labor. Total Direct costs per unit is simply the sum of per-unit costs for direct labor and direct materials. [Photo: Radio final assembly and test, Emerson Radio and Phonograph Corporation, New York, 1945]For the final step in finding product direct costs, Step 3, is simply individual product direct labor cost to the individual product direct materials cost. These figures are the results of Step 2, above. Product A Direct costs per unit calculate as $0.70 + $0.50 = $1.25 / unit Product B Direct costs per unit: $0.50 + $0.50 = $1.00 / unit Direct Cost Summary, Activity Based CostingTable 5 above summarizes direct costs for these product sales, along with the given per unit sales revenues Activity Based Costing Step 4. Identify indirect Activity Pools, Cost Drivers, Unit Costs.In ABC Step 4, the analyst Identifies Indirect (or Overhead) Activity Pools, Cost drivers, and Unit Costs. The analyst, in other words, completes Stage 1 Allocation (or Batch Level Allocation). In ABC, analysts view the indirect or overhead cost contributors as activity pools. Activity PoolsUnder Activity Based costing, an activity pool is the set of all activities necessary for completing a task, such as (a) processing purchase orders, or (2) performing machine setups. To cost activity pools, ABC identifies activity units that drive costs for each pool. For example:
Step 4A. Identify Activity Pools, Their Cost drivers (CDs), and Unit CostTables 6 A and 6B, below, list 5 Indirect or Overhead Activity Pools in producing each product unit, their cost drivers (CDs), and per-unit cost for each activity pool. For example: Step 4B. Calculate Activity Pool Costs for Each ProductTable 6A, moreover, shows the number of CD units (activity units) used for product A, while Table 6B shows these figures for product B. From the given cost of each CD unit, calculate the total cost for each activity pool, for each product. For example, the Activity Pool "Purchase Orders" has a Cost Driver unit cost of $1,800. Product required 75 CD units for this activity. Total Product A indirect cost for this activity pool is thus (75)($1,800) = $135,000 Completing these calculations completes Step 4, ABC Stage 1 Allocation (Batch Level Allocation). Tables 6A and 6B summarize Step 4 data and calculations. Product A: Activity Units, Activity Pools, and Cost Drivers
Product B: Activity Units, Activity Pools, and Cost Drivers
Activity Based Costing Step 5. Find Per-Unit Indirect Costs for Each ProductWhen each product's activity pool cost totals, the analyst can then calculate the cost per product unit, as Table 6C shows. To find product unit costs, the analyst divides the activity pool cost totals by the number of product units. From Table 5, Line 1, the firm produced 900,000 units of Product A and 2,100,000 of Product B. With these figures, the analyst calculates per-product unit costs that appear in the third and fifth columns of Table 6C. For example: For the activity pool Purchase orders (line 17 of Table 6C): Product A Cost per Product Unit = $135,000 / 900,000 = $0.15 Stage 2 Allocation in ABC: Allocating Activity Pools to Product Units
Activity Based Costing Step 6. Calculate Profitability for Individual Products.Using the product revenue figures and the individual product cost figures from ABC steps 1 - 5, the accountant calculates individual product profitabilities (gross margins) [Photo: Grace Kelly with NCR 3000 series accounting calculator, 1950]The Activity Based costing analyst aims to understand product costs accurately, and then understand individual product profitability accurately. The aim, in other words, is to find the true gross profit margins for individual products. Accountants calculate individual product profitability as a gross margin based on product revenues and total product production costs. Table 7 below summarizes these figures, using direct and indirect cost figures from ABC steps 1-5. Each table row indicates the data source and calculation, if any. and profitability calculations. Gross profit margins for Products A and B appear in Row29.
Conclusions: Activity Based Costing ExampleFirst ConclusionABC finds different indirect (overhead) costs per unit for each product. ABC results are thus unlike the traditional costing example above, where indirect costs per unit were the same for both products. Second ConclusionABC analysis recognizes that product A uses more activity pool resources than product B. Third ConclusionOn a per-unit
basis, ABC finds product B more profitable than product A. The gross margin rate of 36.8% for B compares with a gross margin of 26.1% for A. Comparing ABC and Traditional Costing Advantages and Disadvantages to Each ApproachCosting Results from Two ApproachesTable 8 below shows the per-unit profitability estimates for each product from the examples above.
Key Differences Between Costing MethodsThe tables and examples above illustrate some critical differences between the costing methods: Data and Analysis
Overhead Components and Products: Differentiation vs. Aggregation
Direct vs. indirect measurement
Costing Accuracy vs. the Cost of CostingFor the profitability figures appearing in Table 7 above, the Activity Based costing results may be taken as the more accurate results—more closely reflecting the "true" production costs of products A and B—than the profitability figures from the traditional costing approach. Whether or not the improved accuracy justifies the higher expense of applying this costing method, however, is something management will have to investigate and answer before committing to a comprehensive new approach to cost accounting. What is Activity Based Management?Organizations that use Activity Based costing results consistently for decision support and planning are practicing Activity Based management ABM. For example: Pricing Decisions. The heart of the firm's business strategy is a business model specifying margins the firm expects and needs to earn. With accurate knowledge of product costs, the firm can set prices more accurately to achieve target margins. Budgetary Planning. To create an operating budget for the next budge cycle, the firm must anticipate future product costs accurately. ABC shows how indirect product costs depend on production volume for each product, more accurately than traditional cost allocation methods. If the firm can predict future production volume accurately, it can also budget future costs accurately. Adoption of ABC and ABMA few firms began using ABC in the mid-1970s. In the years since then, the percentage of companies and other organizations using ABC increased more or less continuously, but slowly. Nearly five decades after ABC first appeared, however, the majority of companies and organizations in all industries still do not use Activity Based costing, and still do not practice Activity Based management. Implementing Activity Based Management ABMRegarding implementation, Activity Based costing requires
Implementation in large, complex organizations is therefore a labor-intensive and data-intensive undertaking. However, ABC and ABM are becoming more approachable to many companies as a result of two ongoing trends.
ABM Started in ManufacturingWhen a few firms moved to ABC in the 1970s, the benefits of ABC were most apparent in product manufacturing settings, as the two numerical examples above show. From the start, it was clear that in such settings, the ABC is superior to traditional cost accounting for the purposes of:
Activity Based Management: Moving Beyond ManufacturingIncreasingly, however, the value of more accurate costing has become more widely appreciated, leading to the application of this methodology for the purposes of:
What is the difference between ABC costing and a traditional costing system?Traditional costing can only be used for the absorption of manufacturing overheads but activity based costing can effectively be used to allocate manufacturing as well as non-manufacturing overheads like selling, administration etc.
How is activityTraditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received. In this way, long-term variable overheads, traditionally considered fixed costs, can be traced to products.
Why is activityActivity-based costing provides more detailed measures of costs than traditional allocation methods. Activity-based costing can help marketing people by providing more accurate product cost numbers for decisions about pricing and which unprofitable products the company should eliminate.
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