Rethinking Activity

ABC showed that the true cost of certain parts that Chrysler made was 30 times what had originally been estimated, a discovery that persuaded the company to outsource the manufacture of many of those parts. Companies that produce several different products may believe that the benefits of implementing ABC will outweigh the costs. However, management must be willing to use the ABC information to benefit the company. Companies like Chrysler Group LLC have been known to try ABC, only to meet resistance from their managers.

You can avoid this by building your system around only needing information from a small number of sources with the time to gather data. In this article, we explain activity-based costing and its pros and cons, plus provide a formula and examples for how to calculate it. Read on to learn the basics of what activity-based costing is, how to find it, and how it can help your business. Activity based costing is also known as ABC costing, the ABC method, and the ABC costing method.

Chapter 4: Activity

To allocate the costs, divide the total cost in each cost pool by the total amount of activity in the activity driver, to establish the cost per unit of activity. Then allocate the cost per unit to the cost objects, based on their use of the activity driver. Create a set of cost pools for those costs more closely aligned with the production of goods or services.

• A mass-produced industrial robot, for instance, can use the same amount of labour and materials as a customised robot.
• This validation is difficult with traditional ABC, which is based on estimated proportions of time spent and rarely incorporates idle or unused capacity time.
• Most cost drivers are related to either the volume of production or to the complexity of the production or marketing process.
• Hence the reported application for production tasks do not appear as a favorized scenario.
• Learn accounting fundamentals and how to read financial statements with CFI’s free online accounting classes.
• An ABC system can sort through these additional overhead costs and help you determine which customers are actually earning you a reasonable profit.

As a rule of thumb, you could simply assume that practical full capacity is 80 percent to 85 percent of theoretical full capacity. So if an employee or machine is available to work 40 hours per week, its practical full capacity is 32 to 35 hours per week.

Business In Action 3 2

Many firms also use ABC data for the measures required for a balanced scorecard . Calculate the per unit profit for each product using the plantwide approach and the activity-based costing approach. Comment on the differences between the results of the two approaches.

Note that the total overhead for current year is $2,000,000 using activity-based costing, just as it was using a traditional costing method. The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products. The primary difference between activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of activities used to assign overhead costs to products. Traditional allocation uses just one activity, such as machine-hours. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. The cost per setup is calculated to be $500 ($200,000 of cost per year divided by 400 setups per year). Under activity based costing, $200,000 of the overhead will be viewed as a batch-level cost.

Informed Product Selling Price Points

In contrast, for the luxury product, manufacturing overhead costs based on labor hours were higher when compared to the activity-based approach. When considering all relevant activities, overhead costs in manufacturing each product are actually less than that estimated by labor hours only. As a rule of thumb, you could simply assume that practical full capacity is 80% to 85% of theoretical full capacity. Typically, managers would allot a lower rate—say 80%—to people, allowing 20% of their time for breaks, arrival and departure, communication, and training. For machines, managers might allot a 15% differential between theoretical and practical capacity to allow for downtime due to maintenance, repair, and scheduling fluctuations. Whichever approach you prefer, it’s important not to be overly sensitive to small errors. The objective is to be approximately right, say within 5% to 10% of the actual number, rather than precise.

Once you have an ABC system, you can obtain better information about the issues noted below. Harold Averkamp has worked as a university accounting instructor, accountant, and consultant for more than 25 years. Training requirements – Basic training for all employees and workshop sessions for senior managers. Helps fixing the price of a product or service with any desired analytical resolution. Is a modeling process applicable for full scope as well as for partial views.

Time Equations To Capture Complexity

Therefore this model assigns more indirect costs into direct costs compared to conventional costing. Using the plantwide allocation method, calculate the predetermined overhead rate and determine the overhead cost per unit for the inkjet and laser products. Both costing experts had to allocate costs to each of the three grades of gasoline to determine a total cost per grade of fuel and a cost per gallon for each grade. Sales of regular grade fuel were significantly higher than the other two grades.

Activity-based costing can be an effective method for determining the correct product pricing by calculating overhead. When you divide the total overhead in a cost pool by your total cost drivers, you get a cost driver rate. Activity-based costing is a system you can use to find production costs. It breaks down overhead costs between production-related activities. The ABC system assigns costs to each activity that goes into production, such as workers testing a product. Use an activity driver to allocate the contents of each primary cost pool to cost objects.

Abc System Challenges

The capacity of most resources is measured in terms of time availability, but the new ABC approach can also recognize resources whose capacity is measured in other units. For example, the capacity of a warehouse or vehicle would be measured by space provided, while memory storage would be measured by megabytes supplied. In these situations, the manager would calculate the resource cost per unit based on the appropriate capacity measure, such as cost per cubic meter or cost per megabyte. The overhead costs assigned to each activity comprise an activity cost pool. Note that the report highlights the difference between capacity supplied and the capacity used. Managers can review the cost of the unused capacity and contemplate actions to determine whether and how to reduce the costs of supplying unused resources in subsequent periods; they can then monitor those actions over time.

You can see from this analysis that the Deluxe boat consumes four times the machine hours of the Basic boat. At a rate of $30 per machine hour, the Deluxe boat is assigned $1,200 per boat for this activity ($30 rate × 40 machine hours) while the Basic boat is assigned $300 per boat ($30 rate × 10 machine hours).

Activity-based costing helps you identify where you’re wasting money. If you find that some activities cost more than they should, you can find new methods to do something. Activity-based costing can help you to set an accurate budget that breaks down exactly where your money is going—and which products are the most profitable. You may also use traditional costing for reporting externally (e.g., to investors) and activity-based costing for reporting internally (e.g., to managers). When a company asks its employees to report on the time spent on various activities, they have a strong tendency to make sure that the reported amounts equal 100% of their time. However, there is a large amount of slack time in anyone’s work day that may involve breaks, administrative meetings, playing games on the Internet, and so forth. Employees usually mask these activities by apportioning more time to other activities.

This step requires people to understand all of the activities required to make the product. Imagine the activities involved in making a simple product like a pizza—ordering, receiving and inspecting materials, making the dough, putting on the ingredients, baking, and so forth.

Your employees might miscalculate or even exaggerate their time spent working on an activity. Although an activity-based costing system gives you accurate production cost details, it can be difficult to implement.

Activity-based costing is a method to determine the total cost of manufacturing a product, including overhead. It is calculated by taking the cost pool total and dividing it by the cost driver. With activity-based costing, product-focused businesses can get into the nitty-gritty details to better allocate expenses. That means you can more accurately analyze your spending—and price your products. Create cost pools for those costs incurred to provide services to other parts of the company, rather than directly supporting a company’s products or services.

Authors note that activity-based costing system is introspective and focuses on a level of analysis which is too low. On the other hand, they underscore the importance to consider the cost of capital in order to bring strategy back into performance measures. Recently, Mocciaro Li Destri, Picone & Minà proposed a performance and cost measurement system that integrates the economic value added criteria with process based costing . The approach has proven useful in many service industry areas including healthcare, construction, financial services, governments, and other industries. These estimates were made last year and will be used during all of the current year. In practice, companies most frequently set rates for the entire year, although some set rates for shorter periods, such as a quarter.

Unit Cost Card Using Activity

Absorption-costing refers to equally assigning the value of overhead costs across all inventory. This accounting method doesn’t account for products that may have higher indirect costs, but activity-based costing does.

Some disadvantages for using the ABC method include expensive maintenance of cost pools, lengthy installation time and multi-department data reporting. For example, the ABC system requires employees to track how much time they spend on each activity (e.g., research, production, etc.).

Robin Cooper and Robert S. Kaplan, proponents of the Balanced Scorecard, brought notice to these concepts in a number of articles published in Harvard Business Review beginning in 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services.