Activity-Based Costing: Definition and Advantages

Activity-Based Costing: Definition and Advantages

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Chanchal
Chanchal Aggarwal
Senior Executive Content
Updated on Apr 18, 2024 17:52 IST

Activity-Based Costing (ABC) is a precise method of cost accounting that identifies and assigns costs to specific activities. It provides a more accurate reflection of the costs incurred by products or services. It enhances cost control and decision-making by focusing on activities as the primary cost drivers. 

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Activity Based Costing was developed in the 1980s as a response to the limitations of traditional cost accounting methods. Conventional methods often lead to distorted product costs and incorrect decisions. This ABC cost accounting method provides a more accurate picture of product costs by tracing the costs of specific activities involved in producing or delivering a product or service. Let’s understand what activity-based costing is. 

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Table of Content

Activity-Based Costing Meaning

Activity-Based Costing (ABC) assigns costs to products, services, or business processes based on the activities involved in producing or delivering them. It is a more accurate way of determining the true cost of a product or service than traditional cost accounting methods that allocate costs based on volume or direct labour hours.

The ABC process begins with identifying the activities involved in the production or delivery process. We can divide them into two categories: value-added and non-value-added. Value-added activities directly contribute to producing or delivering a product or service, while non-value-added activities do not.

Once the activities have been identified, the next step is to assign costs to each activity. This can be done using various methods, such as direct observation, surveys or interviews with employees, or analysis of financial records. In addition to assigning costs to activities, they are also assigned to products and services. To do this, multiply the activity cost per unit of measure by the units each product or service uses.

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Activity-Based Costing Formula

Activity-Based Costing (ABC) uses the following formula to calculate the cost of a product or service:

Cost per Unit of Activity = Total Cost of Activity Pool/Total Units of Activity​

Where:

"Total Cost of Activity Pool" is the sum of all costs associated with a specific activity.
"Total Units of Activity" represents the total quantity of the specific activity used in the production of a product or service.
ABC allocates costs more accurately by attributing them to specific activities that drive costs in the production process.

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Activity-Based Costing Example

Let's consider the numerical example of a software development company to understand the concept of activity-based costing.

Company XYZ develops two types of software: Mobile Apps and Web Applications. The company has identified two cost drivers: coding hours and testing hours.

Cost Component

Total Cost (₹)

Hours for Mobile Apps

Hours for Web Applications

Total Coding Costs

₹60,000

500

300

Total Testing Costs

₹40,000

400

200

Using the ABC Formula:

1. Cost per coding hour = Total coding costs / Total coding hours
                                          = ₹60,000/(500+300)hours= ₹100/hour

2. Cost per testing hour = Total testing costs / Total testing hours

                                          = ₹40,000/(400+200)hours= ₹66.67/hour

Now, let's calculate the cost of developing each type of software based on their activity usage.

1. Total Cost for Mobile Apps development 

Total cost for Mobile Apps development:
Cost = (500codinghours×₹100/hour)+(400testinghours×₹66.67/hour)

         =₹50,000+₹26,668 = ₹76,668

2. Total cost for Web application development:
Cost = (300codinghours×₹100/hour)+(200testinghours×₹66.67/hour)

         =₹30,000+₹13,334 =₹43,334

Using ABC, the company can determine the precise cost of developing each type of software, considering the coding and testing activities. This information helps in pricing software projects accurately and allocating resources effectively.

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Advantages of Activity-Based Costing

Activity-based costing (ABC) is a method that identifies and assigns costs to the specific activities involved in producing or delivering a product or service. ABC provides several advantages over traditional costing methods, including:

Accurate Product Costing: ABC provides a more accurate picture of product costs. It allows businesses to make better pricing decisions and improve profitability. ABC can more accurately determine the true cost of a product or service. Because it identifies the activities involved in producing or delivering a product or service and assigning costs to them,

Identification of Non-Value-Added Activities: ABC helps businesses identify non-value-added activities that can be eliminated or reduced, leading to cost savings. Distinguishing between value-added and non-value-added activities enables businesses to focus on activities that contribute to producing or delivering a product or service and eliminate those that do not.

Improved Allocation of Indirect Costs: ABC allocates indirect costs more accurately, helping businesses understand the true cost of a particular product or service. Traditional costing methods often allocate indirect costs based on volume or direct labour hours. It can lead to distorted product costs. On the other hand, ABC assigns indirect costs based on the activities involved in producing or delivering a product or service.

Enhanced Decision-Making: ABC provides better information for decision-making. It enables businesses to make more informed decisions about pricing, product mix, and resource allocation. By providing more accurate information about product costs and the activities involved in producing or delivering a product or service. ABC can help businesses make better decisions and improve profitability.

Better Resource Utilization: ABC enables businesses to identify the resources required for each activity and the costs associated with those resources. This information can improve resource utilization and reduce costs by eliminating unnecessary resources or reallocating them to more productive activities.

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Disadvantages of Activity-based Costing

Activity-based costing (ABC) is a method that identifies and assigns costs to the specific activities involved in producing or delivering a product or service. While ABC provides several advantages over traditional costing methods, there are also some disadvantages to consider:

Complexity: ABC can be a complex and time-consuming method, especially for businesses with complex production or delivery processes. It requires a detailed analysis of activities and resources, which can be difficult and time-consuming.

Cost: The implementation of ABC can be costly, particularly if the organization needs the necessary systems and resources. Collecting and analyzing data can be expensive and require additional training and expertise to implement effectively.

Difficulty in determining an appropriate level of detail: Determining the appropriate level of detail for activities and cost assignments can be difficult. Also, it affects the accuracy of the results. If the level of detail is too high, it can lead to unnecessary complexity and costs. If the level of detail is higher, it can result in accurate cost assignments and product costs.

Resistance to change: The implementation of ABC can face resistance from employees who uses traditional costing methods. Implementing the new method effectively can make it challenging and result in accurate and complete data.

Subjectivity: The assignment of costs to activities can be subjective, particularly if the organization does not have clear and consistent guidelines. This subjectivity can lead to differences in cost assignments and affect the accuracy of the results.

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Conclusion 

Activity-based costing is a powerful tool for businesses to determine the true cost of their products or services accurately. By identifying the activities involved in producing or delivering a product or service and assigning costs to them, ABC provides several advantages over traditional costing methods, including accurate product costing, identifying non-value-added activities, improved allocation of indirect costs, enhanced decision-making, and better resource utilization. While it may be more complex than traditional cost accounting methods, it provides a more accurate picture of product costs and can lead to better pricing decisions and cost savings.

Top FAQs on Activity-Based Costing

What is Activity-Based Costing (ABC)?

Activity-Based Costing is an accounting method that assigns costs to products or services based on the activities they require. This approach provides a more accurate reflection of the actual costs of production or service delivery by considering the specific resources consumed by each activity.

How does ABC differ from traditional costing methods?

Traditional costing methods often allocate overhead costs based on a single, volume-based measure, like machine hours or labor hours. In contrast, ABC assigns costs based on multiple activities, ensuring a more precise distribution of overhead costs to products or services based on their actual consumption of resources.

Why is Activity-Based Costing important?

ABC is important because it helps businesses more accurately determine the cost of their products or services. This enhanced accuracy is crucial for setting prices, identifying cost-saving opportunities, and making informed strategic decisions. It is especially useful in complex environments with diverse products and indirect costs.

Can Activity-Based Costing be applied to all types of businesses?

While ABC is versatile and can be applied across various sectors, it is particularly beneficial for companies with diverse products or services, high overhead costs, and those where traditional costing provides insufficient cost detail. However, the complexity and cost of implementing ABC might not be justified for smaller or simpler businesses.

What are the main challenges in implementing ABC?

The main challenges include the need for detailed data collection, the potential complexity of the system, and the requirement for skilled personnel to implement and maintain the ABC system. Additionally, gaining acceptance from management and staff can be challenging, as ABC may significantly change existing processes and cost structures.

About the Author
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Chanchal Aggarwal
Senior Executive Content

Chanchal is a creative and enthusiastic content creator who enjoys writing research-driven, audience-specific and engaging content. Her curiosity for learning and exploring makes her a suitable writer for a variety ... Read Full Bio