Activity-Based Costing for Service Industries: Pros and Cons

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• At the beginning of the 1980s, there was growing discontent with the old methods of allocating costs, partly responsible for the rise in popularity of activity-based costing.
• Therefore, identifying what product/service is causing particular costs can help the business to become more profitable by better understanding the specific activities that are driving the costs.
• For machines, managers might allot a 15% differential between theoretical and practical capacity to allow for downtime due to maintenance, repair, and scheduling fluctuations.
• This analysis is a handy tool to help you determine how much money you need to spend to generate additional revenues.

In the question we’re told that we have a company that uses the ABC system to calculate the unit cost of its products. We are given the expected figures for one particular activity, which is the supplier ordering costs over the next period. We’re told that the supplier ordering costs are expected to be $171,000. We can also see that the company produces two different products – Product A and Product B, and we’re expected to make 80,000 units of both products over the next period. And so essentially, what we can do is we can use all of that information to charge our overheads. First of all, in a modern manufacturing environment, general overhead costs tend to be a much bigger proportion of total production costs.

Step-by-step breakdown

In our example, Product 124 will be assigned some of the company’s costs of special engineering, special testing, and machine setup. Other products that use any of these activities will also be assigned some of their costs. Product 366 will not be assigned any cost of special engineering or special testing, and it will be assigned only a small amount of machine setup. Let’s say you allocate $10,000 in overhead to setting up 4,000 machines (your cost drivers). Activity-based costing (ABC) is a system you can use to find production costs. The ABC system assigns costs to each activity that goes into production, such as workers testing a product.

We can now use this to charge our supplier ordering costs to our product lines. Now we’re a little bit closer to working out our total number of supplier orders because we know how many orders we place for each batch of the two products, and that’s our next step. That means every time we make a batch of Product A, we make 400 units each time. Again, that was probably a safe assumption to make in traditional manufacturing businesses that typically made a small range of products. So, actually, if we have overheads that behave in different ways, we need to understand that behaviour, so we can hopefully work out an accurate cost.

What is Activity-Based Costing?

Without ABC, the cost per unit is $0.40 regardless of the number of units in each batch. If companies base their selling prices on costs, a company not using an ABC approach might lose the large batch work to a competitor who bids a lower price based on the lower, more accurate overhead cost of $0.37. It’s also possible that a company not using ABC may find itself being the low bidder for manufacturing small batches of product, since its $0.40 is lower than the ABC model of $0.46 for a batch size of 5,000 units. With its bid price based on manufacturing overhead of $0.40—but a true cost of $0.46—the company may end up doing lots of production for little or no profit. Note that these rates are lower than those estimated using traditional ABC methods (see again the exhibit “Doing ABC the Traditional Way”). The reason for this difference becomes obvious when we recalculate the quarterly cost of performing the customer service activities.

• You can prevent this by designing your system only to require data from a limited number of sources and give you sufficient time to collect that data.
• While the above is a heavily-simplified example compared to a real-world situation, it shows the importance of allocating indirect costs to get a more accurate financial picture of a company.
• The cost flows are the same for an activity-based costing system, with one exception.
• So, what’s going to be useful first of all, is to work out how many batches of the product will be produced over the course of the period.

We place two supplier orders for every batch of Product B and we make 80 batches over the period according to the figures which are provided. ABC as an approach was initially put forward by the Consortium for Advanced Management International, and was then developed by academics in the 1970s and 1980s. However, what some organisations have found is that even though there are theoretical benefits, it’s a complex process, and ABC brings with it some problems. Mail us on h[email protected], to get more information about given services. Experts are adding insights into this AI-powered collaborative article, and you could too.

Activity-Based Costing Method in Accounting

Recall from that the manufacturing overhead account is closed to cost of goods sold at the end of the period. Simply debit work-in-process inventory and credit manufacturing overhead for the amount of overhead applied. This information is needed to calculate the product cost for each unit of product, which we discuss next. An activity is any process or procedure that consumes overhead resources. So, you can see that it’s a step-by-step approach, particularly if you’re working down to a cost for one unit of a product. We are told that we place one supplier order for every batch of Product A produced.

For example, the labor and resources required to manufacture a mass-produced industrial robot might be comparable to that of a customized robot. However, the mass-produced robot requires far less work from the corporate engineers than the customized one, which is an additional overhead cost. This method uses activities, which are tasks performed by the workers, to calculate how much they cost the company.is an economic concept used to identify the value and effectiveness of an organization’s activities? It uses data about past business processes and costs to forecast future outcomes.

Uses of Activity-Based Costing Method

A really detailed analysis of overheads would have been unjustifiable, because relative to the direct costs, they were quite inconsequential. Imagine that the previously mentioned manufacturing plant produced two items with the exact same price and sales volume. The direct bookkeeping for startups costs for Item A and Item B are $1,000 per month and $500 per month, respectively. However, Item A used up 10% of the manufacturing space, while item B used up 90%. If rent is $1,000 per month, the total rent allocated to item B would be $900 (and $100 to item A).

Well if we’re going to make 200 batches of Product A, that’s going to be a total of 200 supplier orders. So, what’s going to be useful first of all, is to work out how many batches of the product will be produced over the course of the period. However, for Product B maybe it’s a bit more complex in terms of materials or components that used, because we have to place two supplier orders per batch every time we produce a batch of Product B.

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So, the assumption that most production overheads are fixed simply doesn’t apply as consistently in the modern manufacturing environment. And in the long-term, if we understand that certain overheads are influenced by certain things, it gives us the ability to hopefully control our costs in these areas as well. As we said, when it comes to Activity Based Costing (ABC), it’s a more complex process than something such as absorption costing; however, that complexity brings with it, hopefully, much more accuracy. The classical scenario we see here is trying to work out the cost of producing products. Processing loans includes activities such as meeting with customers, reviewing customer applications, and running credit reports.

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