Activity-based costing can only be used to allocate manufacturing factory overhead.
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Allocating overhead costs based on “activities” that actually contribute to overhead costs Show
What is Activity-Based Costing?Activity-based costing is a more specific way of allocating overhead costs based on “activities” that actually contribute to overhead costs. In job-order costing and variance analysis, overhead costs are applied based on a specific cost driver such as labor hours or machine hours. An activity is an event, task, or unit of work with a specific purpose, whether it be designing products, setting up machines, operating machines, or distributing products. Therefore, activity-based costing considers all the potential activities instead of relying on just one variable (either labor hours or machine hours). Generally, activity-based costing is used in the manufacturing industry, as it produces more accurate cost data, generating values that are close to the true cost and can be identified during the production phase. Activity-based costing serves and complements many other analyses and measures, including target costing, product costing, product line profitability analysis, service pricing, and more. Thus, it is used to better understand the company’s true costs, and thereby formulate an appropriate pricing strategy to mitigate unnecessary expenses. Labor Hours Approach vs Activity-Based ApproachLet take a look at the following example to compare the differences: XYZ Company manufactures and sells two types of tables: Standard and Luxury. Annual sales, direct labor hours, and total direct labor hours per year are provided below:
Costs for materials and labor for each table are provided below:
Manufacturing overhead costs total $800,000 every year. The breakdown of these costs among the company’s six activity cost pools is given below. The following six activities contribute to overall overhead costs.
Using the predetermined overhead rate approach with labor hours, the predetermined overhead rate is equal to $16 per labor hour ($800,000 / 50,000 labor hours). Using this information, we can design a cost card for each product. Unit Cost Card Using Labor Approach
Activity-Based Approach to Determine OverheadUsing the activity-based costing approach, we can determine overhead rates for each activity that is relevant to production. The activities listed below are given in this example but companies usually break down the relevant activities.
Next, for each product, we can use the calculated overhead rates to determine the overhead numbers:
Under the activity-based approach, the unit cost card gives different unit product costs for each product. Unit Cost Card Using Activity-Based Approach
Download the Free Template Enter your name and email in the form below and download the free template now! Benefits of Activity-Based CostingActivity-based costing (ABC) can affect the cost distribution process in three ways:
Concluding RemarksBy comparing the first unit cost card (i.e., when manufacturing overhead is applied based on just one variable: direct labor hours) and the second unit cost card (i.e., when manufacturing overhead is applied based on several important activities), we can see that the unit product cost for each product is generally similar. However, the activity-based approach is the more specific and precise way that companies will allocate their manufacturing overhead costs. For the standard product, we can see that the manufacturing overhead cost per unit is much lower for the regular labor-based approach. In producing the product, more overhead costs were actually put into the process than estimated by the labor approach. In contrast, for the luxury product, manufacturing overhead costs based on labor hours were higher when compared to the activity-based approach. When considering all relevant activities, overhead costs in manufacturing each product are actually less than that estimated by labor hours only. Therefore, even though labor hours or machine hours may be a good starting point for companies to get a general idea of potential overhead costs, they can use activity-based costing as an alternative if they are looking to get a more exact assessment of overhead. Related ReadingsThank you for reading the CFI guide to activity-based costing. To learn more about costing and accounting, see the following CFI resources:
Is activityActivity-based costing (ABC) is a method of assigning overhead and indirect costs—such as salaries and utilities—to products and services. The ABC system of cost accounting is based on activities, which are considered any event, unit of work, or task with a specific goal.
What does activityActivity-based costing (ABC) is a methodology for more precisely allocating overhead costs by assigning them to activities. Once costs are assigned to activities, the costs can be assigned to the cost objects that use those activities. The system can be employed for the targeted reduction of overhead costs.
How is overhead allocated in an activityOverhead costs are allocated to products by multiplying the predetermined overhead rate for each activity (calculated in step 4) by the level of cost driver activity used by the product. The term applied overhead is often used to describe this process.
Does activityUsing traditional costing, only manufacturing costs can be assigned to products. Under ABC, both manufacturing and non-manufacturing costs may be assigned.
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