What is Activity Based Costing & Why Is It Needed in Manufacturing Industry

Businesses and manufacturing units use activity-based costing to calculate indirect costs involved in making products. Manufacturing a product involves both direct and indirect costs, so this costing method is perfect for determining the cost of each individual activity in the manufacturing process. Making overhead decisions and improving profit margins can be improved by identifying such costs

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What is Activity Based Costing?

In ABC costing, costs are assigned to individual production processes. Accounting method used to calculate the total cost incurred in manufacturing a product. As it takes into account both direct and indirect costs of production, it is a more accurate process.

An activity-based costing method involves assigning overhead and indirect costs to related products and services. With activity-based costing, indirect costs are assigned to different products and services, such as salaries and utilities.

For companies, activity-based costing consists of identifying product costs, product line profitability analyses, target costing and service pricing strategies. These costing strategies are also reliable.

Examples are listed below.

Example 1: How to calculate the cost of each activityin a production process?

The purpose of activity-based costing is to calculate the cost of each activity that is involved in the production of goods and services. As an example, XYZ company would like to compute the costs associated with machine set up and inspection. Information is readily available (in the table):

By dividing the cost pool total with the cost driver, both machine-set up costs and inspection costs can be calculated. An example is:

• Machine Set-up Costs (2,00,000/340) = 588.24
• Inspection Costs (1,40,000/7500) = 18.67

Example 2: How do I calculate the overhead rate for each activity?

In the table given here, two activities-cost pool and cost driver-have been mentioned.

Using the ABC Costing method, the overhead rate for each activity can be determined by dividing the cost pool by the cost driver.

Example: ABC Costing formula:

• Overhead rate for purchasing activity (cost pool/cost driver) 

120,000/200= 600

• Overhead rate for assembling activity (cost pool/cost driver) 

80,000/1600= 50

Overhead rate for machine maintenance and overhead rate for production steps would also be calculated in a similar way.

Advantages of Activity Based Costing in Manufacturing Industry

ABC costing is a method used to calculate the total costs involved in the creation or manufacture of a product. Activities based costing refines the costing system for measuring the non-uniformity of resource use in an organization. Activities based costing provides the following benefits:

Activity Based Management

Overhead costs can be assigned to products based on activities. The activity-based costing method assigns costs based on activities as opposed to machine hours or direct labor costs.  

Traceable Nature of Indirect Costs

Activity based costing makes the nature of different indirect costs including depreciation, utilities and salaries traceable. It also helps raise the unit cost of low volume products. ABC costing further increases the number of cost pools that are required for assembling overhead costs.

Justification of Overhead Costs

Manufacturing overhead costs can be better justified with activity-based costing. In addition, it helps determine the profit margin of products more accurately, as it identifies which processes have wasted costs.

Realistic Cost

In addition to allocating manufacturing overheads to processes and products, ABC costing also provides realistic costs of manufacturing for specific products.

Activities Other Than Value-Added Services

Adding value to cost processes in such a way as to eliminate all non-value based activities is one of the main components of activity-based costing. This central feature of activity-based costing benefits the entire management team.

Statement of Expenditure

It is also possible to generate a statement of expenditure using this method, which is then used to compare the costs of each activity. Comparing such costs makes it easier to identify the ones that should be eliminated and those that should be improved.

TQM and BPR

In order to improve the financial performance of the company in question, TQM (Total Quality Management) and BPR (Business Process Re-engineering) are useful to the management. This method provides quick and easy determination of transfer pricing, service/product pricing, and cost management. As a result, ABC method of costing has also been defined as a productivity improvement technique.

Explanation of Activity Based Costing Steps

Activate based costing assigns indirect costs to products/services based on the cost of each activity associated with the production process. Consumption costs are also accounted for. Activate based costing involves the following steps:

Step 1: Grouping production overheads into activities

ABC costing uses activities to identify and allocate production overheads, and cost pool is an example of one such activity. Activities and cost pools are usually used interchangeably. Each pool has its own cost driver.

Step 2: Identify cost drivers for each activity

Cost drivers influence the level of cost. One way to calculate the cost of quality control would be to count the number of inspections and the total number of units produced.

Step 3: Calculate Overhead Absorption Rate

For each activity, the Overhead Absorption Rate is calculated. OAR can be calculated by dividing activity cost by information about cost drivers. In this way, overhead rates are allocated to each product and service.

Step 4: Absorb the activity costs into the product

After overheads are assigned to activities or grouped into cost pools, they must be related to or absorbed into cost objects (products and services). The following example illustrates this. You can easily absorb the corresponding quality control costs once you know how many inspections were conducted on a product.

Step 5: Calculate profit/loss/production cost per unit

The profit, loss, or production cost per unit can be determined by multiplying the cost driver with the volume of cost driver units. Multiplying the cost per purchase order by the number of orders required per product for a particular month could be a good example. Profit, loss, or production cost per unit for a particular product for a particular month would be displayed.

FAQs

When is activity-based costing used?

In order to calculate production costs, profitability, and profitability, ABC management tools must be used. Calculations of this kind are also useful for strategic decisions such as outsourcing, pricing, and measurement. Other uses include:

– Increases the reliability of cost data

– Produces almost true costs

– Classifies the costs incurred during production

What are the differences between traditional costing and activity-based costing?

The first difference is that traditional methods evaluate costs by using cost objects and used up resources, while activity-based methods use activities used by cost objects.

The second problem with traditional costing is that overhead rates are added to direct costs. An overhead rate is calculated based on the number of labor hours needed to make a product. In contrast, activity-based costing establishes the overhead rate for each product or activity.

Third, in traditional costing, the company or organization determines the cost of production, while in activity-based management, the costs are determined based on customer feedback and pocket ranges.

A fourth disadvantage is that traditional costing contains just one overhead pool. Nevertheless, taking into account identifiable product parts or labor is one of the core elements of activity based costing.

How to calculate activity cost?

You can calculate activity cost by dividing total overhead in each cost pool by total cost drivers. You would then have the cost driver rate.

Finally, to calculate activity costs, multiply the number of hours, parts, units, etc. used by the activity with the cost driver rate.

Summary

In activity-based costing, indirect costs are assigned to different cost pools. A cost driver further divides these cost pools to calculate overhead absorption rate. For determining not only the rate of profit, but also the sales price, organizations, specifically manufacturing units, use this data or cost set.