Activity based costing is a system that attempts to accurately trace indirect costs to products by allocating indirect costs to activities and then to products based on their usage of the activities. ABC is optimal when accuracy is very important and when indirect costs comprise a large proportion of total costs compared to direct costs.
ABC is commonly used in the manufacturing sector. A reason why it is so useful for the manufacturing sector is fairly obvious, by allocating indirect costs to products based on usage, a company can more accurately see where the resources and energy is going in their company. By figuring out where the money and energy is going, efforts can be focused upon those products that are eating up the most time and energy. This will eventually lead to a drop in cost, in theory, as efforts will be made to reduce the costs on the bulk of the products. Activity based costing is all about efficiency. Efficiency is paramount to success and growth within a company and that is why activity based costing is an effective way to allocate indirect costs within a company to products.
Th four following steps include the activity based costing process:
1. Identify and classify all of the activities in the value chain related to the production of the product.
2. Estimate a total cost for each of the activities identified.
4. Apply activity costs to products using the appropriate cost-driver rate.
For example, a company identifies and classifies machine maintenance as an indirect cost activity. Based on historical data, the company estimates machine maintenance costs to be $1,000 per month. The company determines that batches of product produced on the machine are an appropriate cost-driver allocation base for machine maintenance costs. The machine typically produces 500 batches per month. Thus, the cost-driver rate would be $1,000/500 batches, or $2/batch. So, for each batch of product produced, the company would apply $2 of indirect cost for machine maintenance.
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