Activity-Based Costing (ABC) System

Posted: August 27th, 2021

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Activity-Based Costing (ABC) System

The ABC Concept

ABC system refers to a costing technique that allocates additional and overhead costs to the related services or products by recognizing the relationship between prices, manufactured products, and overhead activities. The ABC method is utilized in manufacturing industries. It is used for costing operating activities such as units of work, individual tasks with particular targets. The respective rates for cost drivers are applied to obtain direct and indirect costs for specific activities. Therefore, the ABC system can improve the accuracy and reliability of data costs by producing actual costs as it classifies costs according to the process.

The Seven Steps of ABC

The seven steps of the ABC system are crucial in assigning costs to their respective drivers by calculating accurate costs in a production process. The first step involves activity identification by determining and grouping particular activities in activity pools, ancillary activities related to a service or product line. The second step requires the classification of processes with the same activities. This may include categories that provide support or are central to production. The third step involves cost allocation based on the first and second steps, where prices are apportioned to the respective activity pool. For instance, human resources costs are allocated to the indirect managerial costs in a company. The fourth step calculates the activity rates by giving activities a real currency value and adding all weights assigned to activity pools. For example, the production labor hours are expressed as a weighted labor rate with benefit costs. Step five involves setting cost-to-cost objects defined as final results offered to consumers. Step six consists of calculating the ABC costs after determining the activities, pools, rates, and things. The costs are calculated as assigned to a particular activity. Finally, the seventh step is preparing and distributing management reports of the costing analysis. Thus, this is done by placing the cost data coherently and concisely for communication purposes to justify the cost analysis in the decision-making process by the internal management.

Numeric Example of ABC

ABC manufacturing company allocates $10,000 in overhead costs to set up 4,000 machines, and 200 devices are used in the production of product X. The cost drivers of producing product X are 4,000 machines. The cost driver rate is$2.50, given by the total overhead costs divided by cost drivers ($10,000 / 4,000). The cost of objects is 200 as it is the number of machines directly related to producing product X. Therefore, the overhead cost in product X is $500, given by the cost driver rate multiplied by the cost object.

Differences between ABC and Traditional System

The ABC systems are supplemental cost accounting processes providing decision-making information to the internal management of a business that the traditional costing approaches lack. However, the ABC cannot displace the traditional costing systems as it does not meet the financial reporting requirements in an organization. The ABC method mainly emphasizes costs that contribute to producing services or products while the traditional costing does not consider indirect costs. Additionally, the ABC system improves the accuracy of indirect cost attained during cost allocation, unlike traditional costing techniques that emphasize direct production costs burdening the products with the fixed costs. Furthermore, the conventional system is used for external reporting in a company to investors, but ABC costing is for reporting internally to a firm’s management for the decision-making process. Therefore, I believe that the firms prefer the ABC system as it is an alternative to the traditional costing system as it is more accurate, specific, and reliable.