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Activity-Based Costing (ABC) is a technique for allocating charges to goods or services in accordance with the activities they necessitate. It serves as an alternative to conventional costing techniques that determine expenses based on volumes or direct worker hours, such as absorption costing or job-order costing.
ABC is aware that various goods and services might use various quantities and types of resources, and that certain costs may be influenced by elements other than volume or labor. ABC gives decision-makers more precise and pertinent information by identifying the cost drivers and tracking them to the goods or services.
The main steps of ABC are:
- Determine which operations cost money for the company. These are the actions taken in order to create or provide goods or services. Ordering supplies, assembling machinery, inspecting goods, etc. are a few examples of activities.
- Based on the resources they use, assign costs to each activity. These are the costs that can be linked directly or indirectly to the activity. Materials, labor, tools, utilities, and other things are examples of resources.
- Determine the factors that affect each activity's cost. These are the elements that affect how much each activity costs. The number of orders, setups, inspections, etc. are a few examples of cost drivers.
- Determine the activity cost rate for each activity. This is the cost per cost driver unit. For instance, if there are 100 orders and the total cost of purchasing materials is $10,000, then the activity cost rate for ordering materials is $10,000 / 100, or $100 per order.
- Allocate costs to goods or services based on the activity they are used for. This is accomplished by dividing the activity cost rate by the number of cost drivers used by each good or service. For instance, if product A needs 10 orders, 5 setups, and 20 inspections, the total cost for product A is ($100 x 10) + ($200 x 5) + ($50 x 20) = $3,000.
The benefits of ABC are:
- For pricing, product mix, profitability analysis, and performance evaluation, it offers more precise and pertinent information.
- Costs can be decreased and non-value-added activities can be found and eliminated.
- Initiatives for quality control and ongoing improvement are supported.
The limitations of ABC are:
- It might be expensive and complex to implement and manage.
- Analyzing and collecting a lot of data is necessary.
- Certain businesses or sectors can find it unsuitable because they prefer or accept traditional costing techniques instead.
