Activity Based Costing (ABC)
Activity based costing approach determines the cost of a product based on the activities performed during its production. ABC provides the opportunity for organisations that use cost based pricing to gain a greater understanding of their costs and to correct anomalies resulting from the distorted view given by conventional volume related costing.
The following example explains the advantages of using ABC.
EXAMPLE:
A company manufactures two products X and Y with the following cost patterns.
|
|
Product X, $ |
Product Y, $ |
|
Direct Material |
27 |
24 |
|
Direct Labour @ $5 per hour |
20 |
25 |
|
Variable Production Overhead @ 6$ per hour |
3 |
6 |
|
Total |
50 |
55 |
Production fixed overheads total $300,000 per month and are absorbed on the basis of direct labour hours. Budgeted labour hours are $25,000 per month. The following is the activity based analysis carried out by the company
|
Activity |
Product X |
Product Y |
Total Cost ($) |
|
Set-ups |
30 |
20 |
40,000 |
|
Material handling |
30 |
20 |
150,000 |
|
Inspection |
880 |
3,520 |
110,000 |
Budgeted production of X is 1,250 units and Y is 4,000 units.
The company wants to make 20% profit on full production cost. Sale price is calculated using a full cost approach and activity based costing.
ANSWERS:
1) Full cost approach
|
|
Product X, $ |
Product Y, $ |
|
Variable Cost |
50 |
55 |
|
Fixed Production Overheads (300,000/25,000 = $12 per labour hour) |
48 |
60 |
|
Total Cost |
98 |
115 |
|
Profit margin @20% |
20 |
23 |
|
Sale Price |
118 |
138 |
2) Activity based costing
|
Activity |
Product X |
Product Y |
Total Cost ($) |
|
Set-ups (30:20) |
24,000 |
16,000 |
40,000 |
|
Material handling (30:20) |
90,000 |
60,000 |
150,000 |
|
Inspection (880:3520) |
22,000 |
88,000 |
110,000 |
|
Total |
136,000 |
164,000 |
300,000 |
|
Budgeted units |
1,250 |
4,000 |
|
|
Overhead per unit |
109 |
41 |
|
|
|
Product X |
Product Y |
|
Variable Cost |
50 |
55 |
|
Production Overheads |
109 |
41 |
|
Total Cost |
159 |
96 |
|
Profit margin @20% |
32 |
19 |
|
Sale Price |
191 |
115 |
Conclusion:
When the results of both approaches are compared we can see a huge difference in sales price. This means that the company was making a loss on sale of product X while it was over charging for product Y, which could lead to customer dissatisfaction and cause a drop in sales.
Complication in activity based costing:
1. Cost accumulation is complex and requires an advanced cost recording system.
2. It is difficult to assign cost to different activities.
3. Where the product range is large, data collection will be complex and proper training will be required in order that staff can carry out ABC costing properly.