Activity based costing is a technique of calculating and monitoring the cost of activities in production. This incorporates tracing resource utilization and costing end outputs. These resources are allocated to activities and activities to cost objects. The cost objects utilize cost drivers to affix activity costs to outputs.
Traditional Absorption Costing v.s ABC
Unlike traditional absorption costing, ABC stresses on cost drivers. The focus of traditional costing is mostly on volume-related drivers, for instance machine hours. On the contrary, activity-based costing also incorporates transaction-based drivers, for example number of orders received.
In short, ABC is a managerial accounting system that marks out overhead costs to activities and then allocates them to objects. It lays out a method of assigning overhead, indirect costs to departments or products that create these costs in the production development.
Why should you opt for ABC?
ABC has confirmed to be a helpful tool for business financing, costing, and accounting. It is mostly used when a business is trying to achieve cost control at a departmental level, to identify unwanted costs, fixing the price of the product etc.
Compared with a traditional approach, activity based costing allocates manufacturing overhead costs to products in a rational manner. It initially allocates costs to activities which derives the cost in real terms. Later, the costs are assigned to the products of ONLY those activities that were specifically carried out.
This way activity-based costing offers a more precise picture of product/service costing, leading to true pricing decisions. Likewise, it identifies activities that are no longer adding value to the production process or are too costly.
Benefits for managers
From a business point of view, it is imperative for managers to be able to effectively utilize finances and strive to reduce unwanted costs. Activity based costing enables the managers to find better ways of allocating and reducing overheads.
In this way, activity based costing technique enables a business to choose which services, products, and resources are resulting in an increase in their profitability, and which are causing losses. It also facilitates managers to devise a budget for the future.
ABC technique is beneficial compared to the traditional method as managers can gain an overall understanding of the expenses that are necessary to keep the business functioning smoothly. Normally, activity-based costing is more effective when used over a long period of time.
Activity Based Costing Example/Problem – AccountingExplanation.com. (2019). Retrieved from http://www.accountingexplanation.com/activity_based_costing_example.htm