What is Activity Based Costing (ABC)? Full Explanation with Example

activity based costing

What is Activity Based Costing?

Activity based costing is the costing approach that identifies all the activities in an organisation, assigns cost and resources to each and every activity.

ABC attempts to provide a better model of the costs of producing products or services and delivering them to customers. It tries to depicts costs more accurately through a deeper understanding both of the activities as well as the resources consumed by each of those activities.

Originally, ABC was quite similar to traditional overhead costing in its overall concepts. Both the approaches involves a flow down of costs from a total overhead cost to the final product cost objects.

Difference Between Traditional Overhead Costing and Activity Based Costing

  • There is creation of more service center in comparison to traditional costing. They are known as activity centers.
  • In traditional costing, allocation of service center cost is to product centers. Whereas in ABC, the possibility is left open that a support activity’s cost should be assigned directly to products without flowing such costs through a production center.
  • Traditional costing allocates indirect costs to products on the basis of the attributes of a single unit. On the contrary, ABC approach focuses on the activities requiring to produce each product.

Activity Based Costing Example

Part R is exclusively supplied to only one customer. He buys 12,000 units per year. Company produces it once in a month with a batch size of 1,000. Each batch consists of one production order processing. The set up time per batch is 3 hours. There are two materials movement per batch. The parts direct cost per unit is Rs 0.20 for material and 0.05 for labor. A 1,000 unit batch consumes 10 machine hours of processing time that is 0.01 machine per hour unit. What are the annual production cost of part R?

Unit Level Costs

Direct Materials ……………………………………………………………….0.20

Purchasing (10% of Direct Material) …………………………………….. 0.02

Direct labor ……………………………………………………………………0.05

Labor support (100% of direct material)…………………………………0.05

Machine support ……………………………………………………………..0.20

Total per unit…………………………………………………………………0.52

Batch Level Costs

Setup ………………………………………………………………………..105

Order processing …………………………………………………………..120

Material handling ……………………………………………………………40

Total per batch……………………………………………………………..265

Annual cost for 12 batches …………………………………………………..3,180

Product level costs

Parts administration…………………………………………………………480

Annual subtotal ……………………………………………………………..9,900

Facilities level allocation……………………………………………………..726

Total annual cost………………………………………………………………10,626

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