The sales price was set after management reviewed the product cost with traditional allocation along with other factors such as competition and product demand. The current sales price, cost of each product using ABC, and the resulting gross profit are shown in Figure 6.9. This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. Service industries also have cost drivers and can benefit from analyzing what drives their costs. The example highlights the importance of correct estimation of the product cost and the usefulness of activity-based costing in achieving that goal.
Requirements for Activity-Based Costing (ABC)
These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity. As technology changes the ratio between direct labor and overhead, more overhead costs are linked to drivers other than direct labor and machine hours. Making this change allows management to obtain more accurate product cost information, which leads to more informed decisions. Activity-based costing (ABC) is the process that assigns overhead to products based on the various activities that drive overhead costs. This helps managers identify non-value-adding activities and process inefficiencies, and increase profitability. Batch-level activities are work actions that are classified within an activity-based costing accounting system, often used by production companies.
How Activity-Based Costing (ABC) Works
- The levels are (a) unit level, (b) batch level, (c) product level, and (d) facility level.
- For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online.
- Table 6.4 illustrates the various cost pools along with their activities and related costs.
Unit level activities are activities that are performed on each unit of product. Batch level activities are activities that are performed whenever a batch of the product is produced. Product level activities are activities that are conducted separately for each product. Facility level activities are activities that are conducted at the plant level.
The number and types of cost pools may be completely different in the service industry as compared to the manufacturing industry. For example, the health-care industry may have different overhead costs and cost drivers for the treatment of illnesses than they have for injuries. Some of the overhead related to monitoring a patient’s health status may overlap, but most of the overhead related to diagnosis and treatment differ from each other.
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Activity-based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities. The calculations Musicality did in order to switch to ABC revealed that the Solo product was generating a loss for every unit sold. Knowing this information will allow Musicality to consider whether they should make changes to generate a profit from the Solo product, such as increase the selling price or carefully analyze the costs to identify potential cost reductions. Musicality could also decide to continue selling Solo at a loss, because the other products are generating enough profit for the company to absorb the Solo product loss and still be profitable. Why would a company continue to sell a product that is generating a loss? Sometimes these products are ones for which the company is well known or that draw customers into the store.
The Calculation of Product Costs Using the Activity-Based Costing Allocation Method
An activity is (a portion of) a work carried out by a (part of) a company. For each activity Kohler created an activity account (Aiyathurai, Cooper and Sinha, 1991, PP 61-64). An activity account is an income or expense account containing transactions over which an activity supervisor exercises responsibility and control (Kohler, 1952, pp, 18-19).
This type of practice is likely to have been developed out of an awareness of the specific costs related to producing a batch of each product. As an activity-based costing example, consider Company ABC, which has a $50,000 per year electricity bill. For the year, there were 2,500 labor hours worked; in this example, this is the cost driver. Calculating the cost driver rate is done by dividing the $50,000 a year electric bill by the 2,500 hours, yielding a cost driver rate of $20. Batch-level activities are one of the five broad levels of activity that activity-based costing account for. Each of these levels is assessed by cost, and these costs are allocated to the company’s overhead costs.
The final level of activity, organization-sustaining activity, refers to activities that must be completed regardless of the products being produced, how many batches are run, or how many units are made. Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation, utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products. In the 1930s, the Comptroller of the Tennessee Valley Authority, Eric Kohler developped the concept of Activity Accounting. The Tennessee Valley Authority was engaged in flood control, navigation, hydro-electric power generation, etc. Kohler could not use a traditional managerial accounting system for these kind of operations.
The predetermined overhead rate found in step four is applied to the actual level of the cost driver used by each product. As with the traditional overhead allocation method, the actual overhead costs are accumulated in an account called manufacturing overhead and then applied to each of the products in this step. The way understanding your paycheck withholdings in which companies will structure the schedule by which machines are set up is an example of how batch-level activity accounting can influence the practices of a manufacturer.
The ABC system of cost accounting is based on activities, which are any events, units of work, or tasks with a specific goal—such as setting up machines for production, designing products, distributing finished goods, or operating machines. Product-level activities are related to specific products; product-level activities must be carried out regardless of how many units of product are made and sold. (For example, designing a product is a product-level activity.) Customer-level activities relate to specific customers. An example of a customer-level activity is general technical product support.
For the past 52 years, Harold Averkamp (CPA, MBA) hasworked as an accounting supervisor, manager, consultant, university instructor, and innovator in teaching accounting online. For the past 52 years, Harold Averkamp (CPA, MBA) has worked as an accounting supervisor, manager, consultant, university instructor, and what is an accrual innovator in teaching accounting online. Now that the steps involved have been detailed, let’s demonstrate the calculations using the Musicality example. Textbook content produced by OpenStax is licensed under a Creative Commons Attribution-NonCommercial-ShareAlike License . The OpenStax name, OpenStax logo, OpenStax book covers, OpenStax CNX name, and OpenStax CNX logo are not subject to the Creative Commons license and may not be reproduced without the prior and express written consent of Rice University.
The unit-level activities are most easily traceable to products while facility-level activities are least traceable. Activity-based costing (ABC) is mostly used in the manufacturing industry. It enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process. Kohler found that a traditional form of managerial accounting was not going to suffice in properly and accurately accounting for the costs that were being incurred by the TVA in the process of carrying out their duties. Kohler introduced the concept of accounting for the costs of these processes by accurately assessing the activities involved in carrying them out.