Activity-based costing can be used to refine which of the following?
CIMA Official Terminology describes activity-based costing as an approach to the costing and monitoring of activities, which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects. The latter use cost drivers to attach activity costs to outputs. Show
ABC was first defined in the late 1980s by Kaplan and Bruns. It can be considered as the modern alternative to absorption costing, allowing managers to better understand product and customer net profitability. This provides the business with better information to make value-based and therefore more effective decisions. ABC focuses attention on cost drivers, the activities that cause costs to increase. Traditional absorption costing tends to focus on volume-related drivers, such as labour hours, while activity-based costing also uses transaction-based drivers, such as number of orders received. In this way, long-term variable overheads, traditionally considered fixed costs, can be traced to products. The activity-based costing process:
What benefits does ABC provide?Activity-based costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions. It increases understanding of overheads and cost drivers; and makes costly and non-value adding activities more visible, allowing managers to reduce or eliminate them. ABC enables effective challenge of operating costs to find better ways of allocating and eliminating overheads. It also enables improved product and customer profitability analysis. It supports performance management techniques such as continuous improvement and scorecards. Questions to consider when implementing ABC
In practice:Activity-based CostingHow Xu Ji achieved standardisation in working practices and processes The Chinese electricity company Xu Ji used ABC to capture direct costs and variable overheads, which were lacking in the state-owned enterprise’s (SOE) traditional costing systems. The ABC experience has successfully induced standardisation in their working practices and processes. Standardisation was not a common notion in Chinese culture or in place in many Chinese companies. ABC also acts as a catalyst to Xu Ji’s IT developments – first accounting and office computerisation, then ERP implementation. Prior to the ABC introduction in 2001, Xu Ji operated a traditional Chinese state-enterprise accounting system. A large amount of manual bookkeeping work was involved. Accounting was driven predominantly by external financial reporting purposes, and inaccuracy of product costs became inevitable. At this time, Xu Ji underwent a series of flotations following China’s introduction of free market competition. The inaccuracy of the traditional costing information seriously impeded Xu Ji’s ability to compete on pricing. The two main tasks for the ABC system were to: trace direct labour costs directly to product and client contracts; and allocate manufacturing overheads on the basis of up-to-date direct labour hours to contracts. Lessons learned The common ‘top-down’ management style and organisational culture among SOEs worked well when instigating innovative ideas and inducing corporate-wide learning. Top management’s commitment to trying out new management ideas and investing in new technology has been the unique feature. An accurate calculation and pricing of goods, products, and services are one of the challenging tasks to tackle for business owners and manufacturers. It only requires an “Exact Right Price” of goods and services. This is what attracts any customers automatically because of realistic transparency and because of worthy pricing. It makes a rise in the margin graph and gives a good profit. But this is not as easy as making a cup of tea, it takes dealers to consider all the account factors where you are standing in the market, have knowledge of what competitors are doing, and make a profit without discouraging the customers. With Activity Based Costing, products and service businesses can get into the core details to allocate the expenses in a better way. That means you can more precisely examine your expenditure and the price of your products. What is Activity Based Costing?Activity-Based costing (also known as ABC costing) defines as a costing technology that identifies the activities of an organization and allocates the cost of individual products and services based on the actual usage of each product. Therefore, this method gives an idea of indirect cost into direct cost compared to conventional costing. Manufacturing and mass-producing businesses with overhead costs use Activity-Based costing to have a clear understanding of where investment is going. Activity-Based costing objectives give a detailed breakdown of the cost, where you can make a list of the actually profitable products. By using Activity-Based costing:
Important Terms Used in Activity-Based CostingThe process of the ABC system involves the use of the following terminologies: 1. Cost Object
2. Cost Driver
How Activity Based Costing work?Now, let’s dive deep into Activity-based costing process on how it works internally. Here are step-by-step instructions which give an in-depth idea of the Activity Based Costing process:
Activity Based Costing vs Traditional CostingThe list of differences between Activity Based Costing vs Traditional costing is given below: Boundary of ComparisonActivity Based CostingTraditional costingDefinitionABC is majorly used for finding the indirect costs.Traditional costing is for finding the cost for the products in advance.Primary focusABC uses multiple cost drivers for multiple activities.It used identical cost drivers for different activities.ScopeABC covers only product costingTraditional costing covers both products as well as period costs.UsageCan be used in external financial statements.Traditional costing cannot be used in reports of external costing.Pricing strategyIt is a less expensive costing method.It is expensive.Types of activity performedIt can be utilized at the Unit level, Facility level.Traditional costing can be utilized at Unit Level, Facility level, product level and batch level.Concluding the differences between Traditional based costing and Activity-based costing, traditional costing is a conventional method of costing, and it is an easy-going method for management. Also, the usage of Traditional costing is suitable for all types of companies that have a low set of costs. Activity Based Costing calculationsABC calculations can be given below:
1. Activity Based Costing formulaActivity Based costing (ABC) is a method to determine the total cost of manufacturing a product, including overhead. It is calculated by taking the total cost pool and dividing it by the cost driver. Identifying product pricing can have a significant impact on a business and allows it to increase its revenue and profit margin when done correctly. The formula for Activity based costing is as follows: ACTIVITY BASED COSTING = COST POOL TOTAL / COST DRIVER 2. Step-by-step breakdown of the formulaThe ABC formula can be described with the core concepts below:This is a product or an item to which the measurement of the cost would require. It is a component that will add a change in the cost of the activity. There are two kinds of cost drivers:
Using the above given ABC formula: Cost Pool total / Cost Driver, the calculation of Machine setup cost is equal to: 3. Estimating the cost per time unit of capacity and estimating the unit times of activities
Activity based costing example: The following details pertain to different activities and their costs for Gamma Ltd. You are required to calculate the overhead rate for each activity. In the above example, it is given five activities, we must allocate the cost based on the cost drivers. Formula - Cost Pool total / Cost driver Each activity pools total cost into its cost driver to get distinct rates. Overhead rate of activity = 1,20,000 / 200 Activity based costing purchase is equal to Now the overhead rate of Purchased activity will be = 600.00 Similarly, find out the ABC cost formula for all activities. Now the total estimated Overhead = 862500.00 4. Deriving cost-driver ratesThe impact of practical capacity Concerning the management customer service department, the survey of ABC work can be distributed about 70%, 20% and 10% of the time where employees spend time on the three activities. But this time can reflect how each employee utilizes and spends it in a productive way. But in the real scenario, the productive time spent is less than the actual time of 32 hours per employee per week was discarded. The calculation of the employees' cost of time estimation will go inappropriately, so the ABC cost drivers give accurate data about the cost and the efficiency of the process. For calculating the cost driver: Cost driver rate = total cost of Finishing activity per day / Cost Driver Units == 40 total cost / 8 hours a day = $5 5. Updating the modelIn the business organization, higher-level administrations can update their ABC costing model which can reflect changes in the system. It helps to bring up new product services to the business and the estimation can be done directly to get the unit time needed for each recent activity, instead of hiring resources. The administrative team can also produce their own set of rates for cost-driven activities. In that majorly there are two factors which affect these changes in rates.
6. Time equations to capture the complexityIn capturing the complexity, we were dependent on the assumption that all transactions are either same or there might be the same amount of time to process the data. But Time-driven ABC costing is not in demand for this type of simplification. To simplify, estimating the process and producing a more accurate cost model than the one which could be possible using traditional ABC techniques. The time-driven approach to Activity Based Costing can simplify the complexities of business than that of the traditional ABC costing system, which might take each process variant as a distinct activity. Example: Consider a case, the Hunter Corporation (not the original name), a large, multinational distributor of scientific services, whose 27 facilities process more than one million orders each month to distribute up to 300,000 different product SKUs to 25,000 customers. Its old ABC model required the employees of its own sales department to estimate each month the percentage of their time that they spend on three activities:
With the time-driven approach, Hunter’s ABC team of analysts was able to combine the three activities into a single departmental process, called inside sales order entry and it took about:
So, it was replaced by a single-time equation: Inside Sales, Order Entry Process Time = 5 + (3 × number of line items) + 15 [if new customer] + 10 [if expedited order] And this was straightforward to implement and easy to understand and resolves by saving time. Requirements for Activity Based CostingThe Activity Based costing system requires the following:
To finalize the ABC systems are those of adoption, implementation, and operation of the system is not end. The benefits could be translating the system designs and operations into action-oriented performance. Finally, it amounts to effective cost management for the success of the system. Activity Based Costing (ABC) Advantages and DisadvantagesThere are several important benefits associated with activity-based costing. It gives a more accurate overview of products or services of costing. Advantages of Activity Based Costing
Disadvantages of Activity Based Costing
Bottomline to Be Concluded AsTo conclude, Activity-Based costing as it is a way of analyzing the organization’s costs to optimize the profit margins. If ABC costing is implemented with the correct understanding of the purpose, it can return great long-term value to the organization. The ABC costing system gives a more accurate and cleaner picture of the production process and the costs associated with each area of production. This allows us to analyze the process and determine the areas that are functioning appropriately and which other areas might need improvement. Activity based costing with project management and its complete guidance can be found in the KnowledgeHut training for Project Management. Frequently Asked Questions (FAQs)1. What is the main focus of activity-based costing?ABC's costings focus will always be on cost drivers, it includes the activities which cause an increase in costs. Based on the type of cost, it might divert focus on volume-related drivers. The main agenda of activity-based costing is to refine the indirect costs related to products, departments, processes. 2. What are the 4 Levels of activity in ABC?Based on the expenses of a company, the levels of ABC are categorized into four distinct levels
3. What are the advantages of activity-based costing?The main advantage of activity-based costing is that it provides a more accurate method in services or products' costs, which also leads to giving more precise and accurate pricing decisions. The in detail on disadvantages of activity-based costing are explained above under Activity Based Costing (ABC) advantages and disadvantages. 4. How is Activity-Based Costing calculated?ABC is a methodology that is used to determine the total cost of manufacturing a product. It is calculated by considering two factors total cost pool and the cost driver. I.e. What is activityABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing.
What is activityActivity-based costing was developed to circumvent the cost allocation problems associated with traditional costing, using a more detailed analysis of the relationship between overhead costs and cost drivers. Many cost drivers may be used to create a more well-founded allocation of overhead costs.
What is an example of activityExamples include square footage that is used per product, and the same would be used to allocate the rent of the factory as well as the maintenance cost of the firm; similarly, the number of purchase orders (i.e., PO) used to allocate the purchasing expenses of the purchasing department.
What are the 4 steps required for activityThe four steps in ABC are identifying activities, estimating their amount and allocation base, computing predetermined rate, and allocating overhead costs.
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