Activity-based costing (ABC) is an accounting method that identifies the activities that a firm performs and then assigns indirect costs to products. An activity-based costing (ABC) system recognizes the relationship between costs, activities and products, and through this relationship, it assigns indirect costs to products less arbitrarily than traditional methods.
Some costs are difficult to assign through this method of cost accounting. Indirect costs, such as management and office staff salaries are sometimes difficult to assign to a particular product produced. For this reason, this method has found its niche in the manufacturing sector.
Activity-based costing (ABC) is mostly used in the manufacturing industry since it enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.
This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis and service pricing. It is also hugely popular since organizations can develop a much better corporate focus and strategy if costs are better grasped.
Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base. Examples of cost drivers include machine setups, maintenance requests; power consumed, purchase orders, quality inspections or production orders.
On the other hand traditional costing is the allocation of factory overhead to products based on the volume of production resources consumed. Under this method, overhead is usually applied based on either the amount of direct labor hours consumed or machine hours used. The trouble with traditional costing is that factory overhead may be much higher than the basis of allocation, so that a small change in the volume of resources consumed triggers a massive change in the amount of overhead applied. This is a particularly common issue in highly automated production environments, where factory overhead is quite large and direct labor is close to nonexistent.
Traditional Costing Vs. Activity-Based Costing
Activity-based costing is more accurate because it takes important factors into account before assigning a cost to a product. However, for this same reason, it is a bit more complicated and time-consuming. It’s also more thorough and considers nonmanufacturing expenses as well, such as administrative and managerial costs.
Traditional costing is a much easier way of determining the cost of a product, since it relies solely on assigning average overhead rates. This also means it won’t always be as accurate, because it doesn’t factor in nonmanufacturing expenses or determine which overhead costs actually affect specific products.
Moreover, Activity-based management (ABM) is a procedure that originated for analyzing the processes of a business to identify strengths and weaknesses. Specifically, activity-based management seeks out areas where a business is losing money so that those activities can be eliminated or improved to increase profitability. ABM analyzes the costs of employees, equipment, facilities, distribution, overhead and other factors in a business to determine and allocate activity costs.
Activity-Based Costing Vs. Activity-Based Costing
Both the ABC and ABM are management tools that help in managing business activities. These two help in improving the performance of a business firm or an organization.
Both are differ in their functions. The Activity Based Coasting relates to the measurements of the cost and the performance of the various activities, cost objects and resources. The ABC mainly recognizes casual relationships of cost drivers to activities. The Activity Based Management mainly focuses on management of activities as a method for improving the value obtained by the customer and the profit got by giving this value.
The Activity Based Management focuses on the various activities and the business processes that the customer needs and is willing to pay for. The Activity Based Management helps in determining the contribution of each person. This is based on the measures for cost, quality and time. The ABMs also support Balanced Scorecard and is considered to be a basis for Business Process Redesign.
The Activity Based Coasting can be called as a subset of Activity Based Management. The ABC helps in improving the costing by outlining the various expenses like supplies, salaries and rent to activities and outlining these activities to services, business processes, products, customers and distribution. One of the basic concepts of Activity Based Coasting is that cost is consumed and consumption is managed.
Requirement 1. Complete the missing items for the two tables.
Begin by completing the table for the total indirect activity costs.