Intro to ABC Costing: Activity-Based Costing

Introduction to ABC Costing

• Activity-Based Costing (ABC) is an overhead allocation method that uses multiple overhead rates to track indirect costs by the activities that consume those costs.
• ABC uses multiple activity bases (or cost drivers) to apply overhead costs to products.
• Examples of activities that consume overhead resources include purchasing and storing materials, supervising direct labor, machine runs, electricity consumption, and equipment maintenance.

Advantages and Disadvantages of Using ABC

• Advantages of ABC:
  • Fair allocation of manufacturing overhead costs
  • Recognizes that manufacturing overhead costs are not all related to production and sales volume
  • More accurate and reliable estimation of product costs
  • Selling prices are reliably determined
  • Provides sufficient and accurate information of costs to identify inefficient products or services
  • Helps control manufacturing overhead costs by managing cost drivers
• Disadvantages of ABC:
  • Difficult to apply and identify overall activities that drive costs
  • Challenging to select the most suitable cost driver
  • Not suitable for small manufacturing companies
  • Too costly and time-consuming to collect and enter data
  • Limited benefits if factory overhead costs are primarily volume-related or small in proportion to total manufacturing costs
  • Does not conform to generally accepted accounting principles, requiring maintenance of two cost systems and accounting books

Primary Benefits of ABC

• More accurate product costing
• Leads to more cost pools and direct assignment of costs based on cost drivers
• Enables enhanced control over overhead costs by tracing indirect costs directly to activities
• Contributes to better management decisions through accurate product costing and informed selling prices

Limitations of ABC

• Can be expensive to use due to increased cost of identifying multiple activities and applying numerous drivers
• Some arbitrary allocation of overhead costs remains, despite more accurate assignment through ABC

When to Use ABC

• Product lines differ greatly in volume and manufacturing complexity
• Multiple product lines require differing degrees of support services
• Overhead costs constitute a significant portion of total costs
• Manufacturing process or product lines have changed significantly (e.g., from labor-intensive to capital-intensive)
• Managers are ignoring existing data and using alternative costing data for pricing and product decisions

Terms Related to ABC

• Activity: any event, action, transaction, or work sequence that incurs costs when producing a product
• Activity Cost Pool: a set of costs attributed to a distinct type of activity
• Cost Driver: any factor or activity that has a direct cause-and-effect relationship with resources consumed