The implementation of an Activity-Based Costing ABC system in a manufacturing company

Activity-based costing (ABC) is a costing method that assigns costs to specific activities or tasks within the production process. Using ABC, overhead costs are traced to products and services by identifying the resources, activities and their costs and quantities to produce output. For instance, the utility cost of running production machines would be included in the running machines cost pool. In order to use activity-based costing correctly, you will need to calculate the cost for each activity identified in Step 1 in order to determine costs. By definition, the allocation of

indirect costs is at least somewhat arbitrary.

• Used in large-scale manufacturing companies, activity-based costing can also be a helpful tool for smaller manufacturers.
• ABC is designed to track the cost of activities, so you can use it to see if activity costs are in line with industry standards.
• New accounting methods sound great in theory, but there

  must be enough benefit from improved management decisions to

  justify the additional work required to provide numbers.

• While that is probably a

  reasonable way to allocate the costs of electricity to run

  machines, its not a desirable way to allocate the cost of quality

  control inspectors.

• And to make it sustainable and repeatable, you need to implement an efficient system throughout your company.
• You have to take so many different factors into account; where you sit in the market, what your competitors are doing and maximising profit margin without deterring customers – to name but a few.

Nevertheless,

accountants have discovered that they can improve the ways costs

are assigned, such as to movies in this case, by using

activity-based costing. Variable costs per unit can at least be measured, and the sum of the variable costs per unit is the marginal cost per unit. The marginal cost is the additional costs caused when one more unit is produced.

Requirements for Activity-Based Costing (ABC)

Unlike the traditional costing method, which allocates overhead costs based on broad categories, the ABC system offers a more accurate understanding of how you use resources and incur different types of costs. We will assume that a company has annual manufacturing overhead costs of $2,000,000—of which $200,000 is directly involved in setting up the production machines. Let’s also assume that the batch sizes vary considerably, but the setup efforts for each https://business-accounting.net/law-firm-bookkeeping-101/ machine are similar. However, as the percentages of indirect or overhead costs rose, this technique became increasingly inaccurate, because indirect costs were not caused equally by all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another. In contrast, for the luxury product, manufacturing overhead costs based on labor hours were higher when compared to the activity-based approach.

Profitable departments can be assigned too much indirect cost causing them to appear unprofitable on paper. Based an evaluation management can choice to discontinue the operations and close a profitable branch because the costs were properly distributed. Because activity-based costing

provides more information, it takes more time than traditional cost

systems. New accounting methods sound great in theory, but there

must be enough benefit from improved management decisions to

justify the additional work required to provide numbers.

Step 2 of 3

Let’s continue with our example from earlier; the total fixed overheads were $224,000. In the table below in Example 2 the total overheads have been split into cost pools and cost driver data for the Ordinary and Deluxe products has been collated. Product pricing is really based on the price that the market will bear, but the marketing manager should know what the cost of the product is, in order Nonprofit Accounting: A Guide to Basics and Best Practices to avoid selling a product that will lose a company money on every sale. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold. The overhead costs assigned to each activity comprise an activity cost pool. But some businesses just have so many costs that it’s hard to keep track!

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The cost driver for cutting fabric is the total yards of fabric used. Let’s say Trendy Clothing uses 2,000 yards of fabric for its T-shirts. By understanding which activities drive the most costs, you can identify areas to improve efficiency and reduce waste. By the end of this read, you’ll be an ABC expert, equipped with the knowledge and tools to take your organization’s profit margins and decision-making processes to the next level. Finance Strategists is a leading financial education organization that connects people with financial professionals, priding itself on providing accurate and reliable financial information to millions of readers each year.