To make a profit, the revenue returned by a product or service must exceed its cost. Activity based costing concepts relate to the allocating costs.
Cost is made up of two components:
* Direct costs (labour, material etc)
* Indirect or Overhead costs
Allocating direct costs is usually straight-forward.
Example: When the cost and quantity of the materials used to make a product are known, the direct cost for materials in the product are easily calculated. Example: Materials in a product: $10.50.
Direct labor for products and services are also readily calculated.
What is not clear is how to allocate the Indirect or Overhead costs to each product and service. In the past the overhead component was a minor contributor to cost. Labor and materials were the main contributors. Organizations doing costing analysis normally assign the direct costs correctly, but then they sometimes use an arbitrary method to assign the indirect costs. This is often unrealistic.
With the traditional method one assumes that there is a relationship between the cost and a volume based measure. i.e. overhead costs are ultimately driven by production volume.
Example: An organization knows its Overhead cost is $200,000 per annum. It also knows that it uses 5,000 hrs of direct labour per annum.
It manufactures a product that has these costs:
Labour: 2 hours at $55 per hour: $110
Total direct costs: $120.50
Indirect costs: allocate on the basis of direct labour hours:
2 hours x 200,000/5,000 = $80
Total cost: $200.50
How realistic is this cost calculation? The answer is usually – no one knows! A competitor sells the same product for $160. Are they selling at a loss, or do they have a better understanding on what drives the cost of their product? OR: A competitor sells the same product for $1,000. Are they overpricing their product, or do they realize something about overhead allocation that is unknown to you? You need to understand costs to make an informed decision on how to price services and products.
Traditional techniques tend to give wrong costings because they use simple methods to allocate cost to products. This can lead to some products being penalized because of the unfair basis of allocation chosen. A result of bad costing information can be management taking wrong business decisions and losing business.
Activity based costing (ABC)
Today, for many organizations indirect overheads are much bigger than direct costs.
The contribution of the overhead component in costing is today very significant.
Many businesses do not understand the components of their overhead costs and what drives them. Activity based costing is a well recognized technique that is used for this purpose. It enables organizations to assign indirect overhead costs to products or services much more realistically than was done in the past.
ABC recognizes that many of the overheads are unaffected by changes in production volume. These overheads (indirect costs) are incurred in service support functions like order entry, accounting, purchasing materials, planning production, quality control etc. Different products require different volumes of these activities. For example, small lots of new products might use more resources than large lots of existing products. It is the volume of these activities (not the volume of product) which uses the resources and thus incurs the cost.
An organization performs activities to do its business. These activities define the kind of business you are in: a ship owner has an activity to unpack boats; an accounting firm prepares tax returns; a manufacturer produces products; a council delivers services; a university teaches students. All activities consume resources. It is the consumption of these resources that adds to overhead costs.
The basis of ABC Costing is: look at the activities required to produce the cost of the product or service. The activities consume resources and the cost of these can be calculated. The amount of activity required for each product and service is determined, hence the real cost can be determined.
What’s what in Activity Based Costing Concepts
* The ACTIVITY is the work that is done.
* The RESOURCE is what the activity uses to do the work eg people, equipment, services. Resources cost money.
* The cost of the activity depends on the quantity of resources used to accomplish the activity.
* The cost driver for an activity is the factor that influences the amount of the resources that will be consumed by this activity.
Example: the activity is delivering goods. The costs of this activity include the truck drivers’ wages, fuel, depreciation of the truck, insurance, etc. The quantity of the resources that will be consumed by this activity are influenced by the number of deliveries made per year. Hence the cost driver could be the number of deliveries. A cost driver is designed to allocate the delivery activity cost pool to the cost objects.
(Note: The software has the facility to enter and change the cost drivers as better information becomes available).
* The activity driver measures how much of the activity is used by the cost object. Example: Product A is delivered once a month, whereas product B is delivered once a week. Products A and B require a different number of deliveries, hence the cost of the delivery activity should be assigned to each product on the basis of the number of deliveries each uses.
* The cost object is whatever it is you wish to cost. It could be a product, service, process, job or customer.
While traditional costing arbitrarily allocates overhead costs, ABC traces overhead costs by looking at the activities that each product and service calls upon. With ABC the products consume the activities. It is the activities that cost money.
If there were no activities, no resources would be consumed. It is the activities that you do that define your business.
Activity based costing allocates costs on the organisation’s best estimate of the appropriate cost drivers and involves many value judgments. Activity based costing concepts avoid costing distortions because realistic cost drivers are assigned individually to each activity cost pool. Activities can be controlled, wastage can be measured and reduced, unused capacity can be measured and managed, costs can be assigned to products and services based on their “true” consumption of resources. Executives understand the costs triggered by the cost objects and can manage them.
The costings produced by ABC Focus will be more realistic because all of the resources are assigned to the cost objects in a considered way.
See ABC Steps