Activity based costing
Activity based costing (ABC) may be defined as a method for identifying activities in the organization and assigning cost to each of the activities with resources for all of the products and/or services, keeping in mind the actual consumption by each. The ABC system can recognize the relationship between the costs, activities and products and assign individual costs accordingly.
This method can help companies predict the cost elements for each of the products, activities and services it offers. Its significance can be expressed in helpful information about the following:
- Identifying and eliminating unprofitable products and services,
- Identifying and eliminating ineffective concepts which lead to earning less money on a product than it would be possible with another concept.
ABC is a better and more refined way to calculate product’s and service’s cost than the traditional costing method. It relies on the following steps:
- Identifying activities involved in the production process.
- Classifying each activity according to the cost hierarchy.
- Identifying and accumulating total costs of each activity.
- Identifying the most convenient cost factor for the given activity.
- Calculating the sum of the units of the cost factor relevant to each of the activities.
- Calculating the activity rate, for example the cost of each activity per unit of its cost factor.
- Applying the cost of each activity to products based on its activity usage by the product.
Types of business in which ABC should be used
Activity based costing can be used in any industry, since its main point is to allocate general cost to individual cost centers. However, some industries, like manufacturing, can have greater benefits from it. Any company that produces an item in more than two activities needs to distribute the cost according to the consumption of material, labor etc.
Some businesses and companies can benefit more from one of the alternatives instead of applying the activity based costing. The best alternative for it is lean accounting. Its purpose is to support the lean enterprise as a business strategy. By using this method, activity based costing gets replaced by:
- lean-focused performance metrics
- simple summary direct costing of the value streams
- using a box score or reporting and decision making
- plain language financial reports
- eliminating the need for transactional control systems
- changing the traditional budgeting system
- value-based pricing