Answer:

Introduction :

• Activity-based costing (ABC) is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. This model assigns more indirect costs (overhead) into direct costs compared to conventional costing.
• Many businesses use the cost of goods sold (COGS) to determine how much it costs to create a product. But, COGS focuses on direct costs and does not include indirect expenses like overhead.
• Some businesses take their overhead expenses and allocate them evenly among all products. But because some products use more overhead expenses than others, the cost of making each product is inaccurate under this method.

Body :

Because activity-based costing breaks down the costs that go into creating a product, it has many uses in business.

To use activity-based costing, you must understand the process for assigning costs to activities.

• First, identify which activities are necessary to create a product. Then, separate each activity into its own cost pool, which is a group of individual costs associated with an activity. Determine the total overhead of each cost pool. For example, purchasing could be its own cost pool.
• Next, assign activity cost drivers to each cost pool. Cost drivers are things (e.g., units, hours, parts, etc.) that control the changes in costs. For example, purchasing costs are driven by the number of parts purchased.
• Divide the total overhead in each cost pool by the total cost drivers to get your cost driver rate.
• Lastly, compute how many hours, parts, units, etc. that the activity used and multiply it by the cost driver rate.

Conclusion :

• Traditional costing is more simplistic and less accurate than ABC, and typically assigns overhead costs to products based on an arbitrary average rate.
• Both methods estimate overhead costs related to production and then assign these costs to products based on a cost-driver rate. The differences are in the accuracy and complexity of the two methods.
• ABC is more complex and more accurate than traditional costing. Of all the tools available to accountants and business managers, the activity-based costing (ABC) method is able to increase profitability by saving the business time, money, and resources..
• When all direct and indirect costs are allocated to a product, managers begin to get an idea of which business processes are performing well and which are inefficient. They can then streamline these processes by allocating more resources to profitable activities and eliminating practices that are costly and wasteful.
• Overall, profitability is increased as a result of more accurate product pricing which can allow companies to offer competitive pricing while maximizing their returns.

Reference :

• For example, you make soap. Soap A requires more overhead, like testing, than Soap B. Using activity-based costing, you assign the right overhead costs to the appropriate products. That way, your overhead is higher for Soap A than B.

Check out this example to help further illustrate the process:

• Let's figure out how much you are spending on utilities to create a product. To do this, you estimate that your total utility bill is $20,000 for the year.
• You determine that the cost driver impacting your utility bill is the number of direct labor hours worked. The number of direct labor hours worked totaled 1,000 hours for the year.
• Divide your total utility bill by your cost driver (the number of hours worked) to get your cost driver rate. Your overhead application rate is $20 ($20,000 / 1,000 hours).
• For this particular product, you used utilities for 3 hours. Multiply the hours by the cost driver rate of $20 to get $60.