ABC COSTS: STEPS, IMPORTANCE, ADVANTAGES, EXAMPLE - DUDAS - 2025

The ABC costs or activity - based costing is defined as an accounting model for calculating costs, which tracks resource consumption and identifying the activities that a company, then allocating indirect costs to products final cost objects.

Resources are assigned to the activities of a company and these activities are assigned to all cost objects (services or final products), based on the actual consumption of each one. The latter use cost determinants to link the costs of activities to outputs.

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This costing model is used for target price calculation, product cost calculation, product line profitability analysis, customer profitability analysis, and service pricing.

It's also popular, because organizations can develop a much better corporate focus and strategy if costs are better captured.

Cost process improvement

Activity-based costing improves the costing process in three ways. First, you expand the number of cost groups that can be used to assemble overhead costs. Instead of accumulating all the costs in a group of companies, the costs per activity are combined.

Second, it creates new bases for assigning overhead costs to items, so that costs are assigned based on cost-generating activities, rather than volume measures such as machine hours or direct labor costs.

Finally, ABC alters the nature of various indirect costs, making costs that were previously considered indirect, such as depreciation, or inspection, can be attributed to certain activities.

ABC shifts the overhead costs from high-volume products to low-volume products, thereby raising the unit cost of low-volume products.

ABC cost model

The ABC cost is an accounting model that identifies and assigns costs to general activities, then assigning those costs to products.

The ABC cost model is based on activities, which are any event, unit of work, or task with a specific objective, such as setting up machines for production, designing products, distributing finished products, or operating equipment.

An ABC cost system recognizes the relationship between costs, overhead activities, and manufactured products. Through this relationship, it assigns indirect costs to products in a less arbitrary way than traditional methods.

However, some costs are difficult to allocate with this cost accounting model. For example, office staff salaries are sometimes difficult to assign to a product. For this reason, this model has found its niche in the manufacturing sector.

Activity monitor

Activities consume resources and are considered cost objects. Under the ABC model, an activity can also be thought of as any transaction or event that is an activity handler.

The activity driver, also known as the cost driver, is used as an allocation base.

Examples of activity controllers are: maintenance requests, energy consumed, purchase orders or quality inspections.

Activity levels

Unlike traditional cost measurement systems, which rely on counting a production volume, such as machine hours and / or direct labor hours, to assign indirect costs to products, the ABC system classifies five general levels of activity.

These levels are not related to how many units are produced. They include activity at the batch level, activity at the unit level, activity at the customer level, business support activity, and activity at the product level.

Steps to implement it

Activity costs

ABC is designed to track the cost of activities, so it can be used to see if the costs of an activity are in line with industry standards, as management is focused on reducing costs.

Customer profitability

Although most of the costs incurred for customers are simply product costs, there is also an overhead component, such as high levels of customer service, product return handling, and cooperative marketing agreements.

An ABC system can sort out these additional overhead costs and help determine which customers are actually generating a reasonable profit.

Distribution costs

The typical company uses different distribution channels to sell its products, such as retailers, the Internet, distributors, and mail-order catalogs.

Most of the cost of maintaining a distribution channel is an overhead, so by being able to reasonably determine which distribution channels have excessive costs, you can change the way they are used, or even eliminate unprofitable channels.

Make or buy

ABC provides a comprehensive view of every cost associated with making a product, so that you can see precisely what costs will be eliminated if an item is outsourced, and compare them to the costs that will remain.

Margins

With proper allocation of overhead from an ABC system, margins can be determined for various products, product lines, and entire subsidiaries.

This is very helpful in determining where to put the company's resources to get the highest margins.

Minimal price

The price of the product is actually based on the price that the market will pay, but you must know what the cost of the product is, in order to avoid selling a product that loses money on each sale.

ABC is very good at determining what overhead costs should be included in this minimum cost, depending on the circumstances under which the products are sold.

Advantages and disadvantages

Advantage

The fundamental advantage of using an ABC system is to determine more precisely how indirect costs are used in the product.

- ABC costs provide a more accurate model of product / service costs, leading to more accurate pricing decisions.

- Increase understanding of overhead and activity drivers.

- It makes costly and non-value-added activities more visible, allowing managers to reduce or eliminate them.

- It allows a better analysis of the profitability of the product and the client.

Decision making

ABC has been used to support strategic decisions such as pricing, outsourcing, identifying and measuring process improvement initiatives.

With ABC, a company can solidly estimate all the cost components of products, activities and services, being able to help with information in the decision-making of the company to:

-Identify and eliminate unprofitable products and services, reducing the prices of those that are overvalued.

-Identify and eliminate production processes that are ineffective, assigning processing concepts to produce the same product with better performance.

Disadvantages

Fixed as variable costs

The key problem with ABC is that it treats fixed costs as if they were variable. For this reason, it presents an inaccurate picture that can lead to wrong decisions.

Cost tracking

Some overhead costs are difficult to assign to products, such as the CEO's salary.

These costs are called "business support". They are not assigned to products, because there is no method for it.

However, this group of unallocated overhead costs must be covered by the contribution of each of the products.

Installation time

The ABC system is very difficult to install. As a rule, its implementation lasts several years when a company tries to install it in all its product lines.

It is difficult to maintain a high level of budget support and administration over time.

Unused time report

When employees are asked to report time spent on various activities, there is a strong tendency for reported amounts to equal 100% of their time.

However, there is plenty of free time in anyone's work day, such as breaks, meetings, Internet games, etc. Employees mask these activities by allocating more time to other activities.

These inflated numbers are going to represent a misallocation of costs in the ABC system.

Example

Alex Erwin founded the Interwood furniture brand 10 years ago. Although he has 50 skilled carpenters and 5 salespeople on his payroll, he has taken care of the accounting himself.

Interwood's total budgeted manufacturing overhead for the year is $ 5,404,639. The total budgeted labor hours is 20,000.

Alex applied the traditional cost method for 10 years. The default overhead rate was based on total labor hours. However, you hired a consultant who recommended using the ABC cost model.

The Platinum customer recently placed an order for 150 units of 6-seater type sofas. The order is expected to be delivered in a month. Platinum will be billed at cost plus 25%.

Because the benefit of the activity-based costing system exceeds its cost of implementation, Alex sat down with Aaron Mason, his chief engineer, to identify the activities that the company performs in its sofa division.

Establishment of activities

Next, the annual cost (A) of each activity was calculated, its activity controller and its use (B) were identified for each activity, and the standard rate (C) was calculated for each activity. The results are summarized below:

Once the order was ready to be packed, Aaron delivered a report of the total cost incurred, listing the activities performed for that order, as shown:

Since you already have all the necessary data, you can calculate the cost of the order using ABC costs.

Cost allocation to order

In ABC cost, the cost of direct materials, the cost of purchased components, and the cost of labor remain the same as in the traditional cost of the product.

However, the assigned value of manufacturing overhead is more accurately estimated.

The following spreadsheet estimates the manufacturing overhead that should be allocated to the Platinum order:

-Direct materials: $ 25,000

-Components purchased: $ 35,000

-Labor cost: $ 15,600

-General manufacturing expenses: $ 82,121

Therefore, the total cost of the order under the activity-based cost is: 25,000 + 35,000 + 15,600 + 82,121 = $ 157,721.

Based on this precise estimate of the cost of the order, based on the ABC model, the invoice should increase to: ($ 157,721 × 1.25) = $ 197,150.

References

1. Wikipedia, the free encyclopedia (2019). Activity-based costing. Taken from: en.wikipedia.org.
2. Will Kenton (2019). Activity-Based Costing (ABC). Investopedia. Taken from: investopedia.com.
3. Steven Bragg (2019). Activity based costing. Accounting Tools. Taken from: accountingtools.com.
4. My Accounting Course (2019). What is Activity Based Costing (ABC)? Taken from: myaccountingcourse.com.
5. Rachel Blakely-Gray (2018). Activity-Based Costing for Small Business. Patriot Software. Taken from: patriotsoftware.com.
6. CGMA (2013). Activity-based costing (ABC). Taken from: cgma.org.
7. Xplaind (2019). Activity-Based Costing. Taken from: xplaind.com.