# Activity Based Costing (ABC)

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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.

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.