Definition
Activity Based Costing (ABC) is a financial methodology that assigns costs to products and services based on the resources and activities they consume. It identifies individual activities from start to finish and assigns a specific cost to each. The aim of ABC is to improve cost accuracy and to help businesses identify and eliminate unproductive processes.
Key Takeaways
- Activity-Based Costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to products and services according to the actual consumption by each. It offers more accurate cost information as it takes into account the cost of business operations and the actual effort involved in producing a product or service.
- ABC helps organizations to understand where they are spending money and how these expenses relate to the revenue generated. It can help identify inefficient areas where the costs are high but the output is low, facilitating better resource allocation and improved profitability.
- The system can be complex and time-consuming to implement. Despite the initial complexity, it can reveal hidden waste or areas for improvement that traditional costing methods might miss, leading to substantial savings in the long run.
Importance
Activity Based Costing (ABC) is an important finance term because it provides a more accurate understanding of overhead costs and thus impacts the profitability analysis and pricing strategy of a company.
ABC allows companies to precisely assign costs to products and services by determining the exact activities that go into their production, allowing for a more accurate and detailed measurement of cost behavior and identification of inefficiencies.
This can reveal hidden costs that were not identifiable at the product line or total company level before.
Consequently, it helps in cost control, internal process improvement and strategic decision-making, ultimately improving the financial performance and competitiveness of the company.
Explanation
Activity Based Costing (ABC) serves a significant purpose in financial management by providing in-depth insight into the true cost associated with producing a certain product or service. The primary role of ABC is to identify, describe, assign costs to, and report on agency operations.
It takes into account every activity involved in accomplishing a task, unlike conventional costing methods that might simply allocate costs based on the product volume or a single overhead rate. With ABC, businesses can develop a more efficient, cost-effective structure by attribiting indirect costs to the items that actually use them.
ABC is used for product costing, cost control, cost reduction, and cost management, with its usefulness lying in complexity and diversity scenarios where conventional costing methods may provide distorted results. By showing more accurately how resources are consumed, ABC aids in identifying non-value adding efforts, wastage, and inefficient processes.
It’s a key tool for pricing decisions by giving a clear picture of costs associated with individual products or services. Thus, ABC is an essential element in strategic decision making, guiding management towards more profitable routes and improving overall business performance.
Examples of Activity Based Costing
Manufacturing: Activity Based Costing (ABC) is extensively used in the manufacturing sector. A good example would be a car manufacturing company like Toyota. To manufacture a car, various activities are involved such as design, material sourcing, production, assembly, quality control, and shipping. Each of these activities has a cost attached to it. ABC helps Toyota allocate costs to each of these activities which in turn helps in understanding the cost of producing a single car and pricing it accordingly.
Health Care: Hospitals also utilize ABC for cost allocation. For instance, a hospital provides various services like surgery, diagnostics, and therapeutic treatments. These services involve different activities like nursing care, medical supplies, room charges, medications etc. Using ABC, the hospital can allocate costs to each service based on the resources used, helping them with budget planning and pricing their services properly.
Telecommunications: Companies like AT&T use ABC to better understand the cost of their services. For instance, providing a broadband internet connection involves costs related to infrastructure, maintenance, customer service, etc. By using ABC, AT&T can identify which activities are driving their costs and make necessary adjustments to either reduce costs or adjust their service pricing.
FAQs on Activity Based Costing
What is Activity Based Costing (ABC)?
Activity Based Costing (ABC) is an accounting method that identifies and assigns costs to overhead activities and then assigns those costs to products. An activity based costing (ABC) system recognizes the relationship between costs, overhead activities, and manufactured products, and through this relationship, it assigns indirect costs to products less arbitrarily than traditional methods.
What is the purpose of Activity Based Costing?
The purpose of Activity Based Costing is to accurately distribute cost overheads to the specific items or services that actually use these overheads. This allows for more granular understanding of where costs are being used, and thus where improvements can be made to save money.
What are the steps in Activity Based Costing?
The steps involved in Activity Based Costing are:
1. Identify activities that consume resources and assign cost to them.
2. Identify the cost drivers associated with each activity.
3. Compute a cost rate per cost driver unit or transaction.
4. Assign costs to products by multiplying the cost driver rate by the volume of cost driver units.
What are the advantages of Activity Based Costing?
The advantages of Activity Based Costing are:
1. Better product costing, understanding overhead, process improvement, better budgeting and monitoring.
2. It enhances the control of overhead costs and under ABC, managers can identify high overhead costs per unit and find ways to reduce the costs.
3. It is more scientific, as it more accurately assigns overhead costs by using multiple cost drivers.
What are the limitations of Activity Based Costing?
The limitations of Activity Based Costing are:
1. ABC can be expensive to implement.
2. The selection and measurement of cost drivers can be challenging.
3. It may not be as helpful for companies with a low volume of products or services.
Related Entrepreneurship Terms
- Cost Driver
- Overhead Costs
- Cost Objects
- Direct Costs
- Indirect Costs
Sources for More Information
- Institute of Management Accountants (IMA) – A global association of accountants and financial professionals in business that provides information on managerial accounting topics like Activity Based Costing.
- American Institute of CPAs (AICPA) – Represents the CPA profession nationally regarding rules, standards, and professional ethics and offers resources on various financial topics, including Activity Based Costing.
- Investopedia – A website specializing in investment and finance education that provides an extensive library of resources on financial terms, including Activity Based Costing.
- Accounting Tools – A site containing a vast amount of information about accounting, auditing, and corporate finance, including detailed articles on Activity Based Costing.
