Activity based Costing

Activity-based costing is a costing method that assigns indirect costs to activities and to the products based on each product’s use of activities. Activity-based costing is based on the premise: Products consume activities; activities consume resources. Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities. Activity based costing is an important domain in the PMP exam, so the best PMP prep course will help you score well in this section.

Business people have moved to adopt ABC by a desire to improve costing accuracy, mainly to get closer to the actual cost and true profitability of individual products and services. And, they also move to ABC to understand better the actual costs and return on investment from projects, programs, or other initiatives. 

Traditional Cost Accounting vs. ABC

For example, consider a firm that manufactures automobile parts through a sequence of machine operations on a metal stock. In such settings, traditional cost accounting views "product production costs" as either direct costs or indirect costs (or overhead).

Sources of Direct Costs

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:

• Direct labour costs.
  These can include the cost for person minutes or person-hours per product unit for running production machines.
• Direct materials.
  Direct materials costs might include costs per product unit for metal stock, fasteners, and lubricants.

Sources of Indirect 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 time periods. These might include indirect costs such as the following:

• Materials purchase order costs.
  Firms typically do not order materials for each product unit, but instead, for entire batch runs. They may also order supplies to cover a specific timespan.
• Machine set up costs. 
  Manufacturing firms do not set up production machines for each product unit. They are set up instead for the production run of each product model.
• Product packaging costs. 
  Manufacturers can sometimes package multiple product units in a single package. And, they may fill numerous packages in a single packaging run.
• Machine testing and calibration costs.
  Manufacturing firms perform these operations regularly and often, but not for each product unit.
• Machine maintenance and cleaning costs.
  Firms usually perform these operations only after producing multiple product units. 

In ABC, the direct costs are allocated as is done in traditional method. It is only the overheads or indirect costs are allocated differently.

An Illustration:

Let us take an example to understand the difference in costing in ABC vs Traditional costing.

Let's examine the concept of activity based costing by looking at two common manufacturing activities: (1) the setting up of a production machine for running batches of products, and (2) the actual production of the units of product. 

We will assume that a company with following information: 

1. Total annual manufacturing overhead costs of $2,000,000—
2. Out of which $200,000 is directly involved in setting up the production machines. 
3. During the year the company expects to perform 400 machine setups. 
4. Let's also assume that the batch sizes vary considerably, but the setup efforts for each machine are similar. 
5. Let's assume that the remaining $1,800,000 of manufacturing overhead is caused by the production activities that correlate with the company's 100,000 machine hours.

For our simple two-activity example, let's see how the rates for allocating the manufacturing overhead would look with activity based costing and without activity based costing:

Next, let's see what impact these different allocation techniques and overhead rates would have on the per unit cost of a specific unit of output. Assume that a company manufactures a batch of 5,000 units and it produces 50 units per machine hour, here is how the cost assigned to the units with activity based costing and without activity based costing compares:

If a company manufactures a batch of 50,000 units and produces 50 units per machine hour, here is how the cost assigned to the units with ABC and without ABC compares:

As the tables above illustrate, with activity based costing the cost per unit decreases from $0.46 to $0.37 because the cost of the setup activity is spread over 50,000 units instead of 5,000 units. Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch. 

If companies base their selling prices on costs, a company not using an ABC approach might lose the large batch work to a competitor who bids a lower price based on the lower, more accurate overhead cost of $0.37.

 It's also possible that a company not using ABC may find itself being the low bidder for manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units. With its bid price based on manufacturing overhead of $0.40—but a true cost of $0.46—the company may end up doing lots of production for little or no profit.