What is Activity Based Costing & Why Is It Needed in Manufacturing Industry

Activity based costing is used by businesses and manufacturing units for calculating indirect costs involved in making a product. This costing method is ideal for identifying the cost of each individual activity in the production process for manufacturing a product involves both direct and indirect costs. Identifying such costs is useful in improving profit margins and making overhead decisions.

What is Activity Based Costing?

ABC costing assigns costs to each activity of the production process. It is an accounting method used for calculating the total cost incurred in the manufacture of a product. This process is a more accurate one as it covers not just the direct costs of production but also the indirect ones such as overhead, etc.

Activity based costing is an accounting method meant for assigning overhead and indirect costs to related products and services. Moreover, activity based costing is the process of assigning indirect costs in the form of salaries and utilities to different products and services.

Activity based costing for companies is all about devising the appropriate pricing strategy for identifying product costing, product line profitability analysis, target costing and service pricing strategies. To add to this, such costing strategy also increases the reliability of cost data.

---

What are Some of Best Activity Based Costing Examples

Example 1: How to calculate the cost of each activityin a production process?

As mentioned earlier, activity based costing calculates costof each activity that is involved in the production of goods and services. For instance, XYZ company wants to calculate machine-set up costs as well the costs involved in inspection activities. It has the following information (given in the table) available:

Activity	Budgeted Cost	Cost Driver	Cost
Machine Set-up	2,00,000.00	Number of Machine-Setups	340
Inspection	1,40,000.00	Inspection Hours	7,500

Using the ABC costing method, both machine-set up costs and inspection costs can be calculated by dividing cost pool total with cost driver. XYZ company would use the following formula:

• Machine Set-up Costs (2,00,000/340) = 588.24
• Inspection Costs (1,40,000/7500) = 18.67

Example 2: How to calculate overhead rate for each activity?

In the table given here, have been mentioned these two activities- cost pool and cost driver.

Using the ABC Costing method, overhead rate for each activity can be calculated by dividing cost pool with cost driver.

Cost Pool- Activity	Estimated Overhead	Cost Driver	Expected Activity
Purchase	120,000	Number of purchase orders	200
Production steps	202,500	Number of set-ups	250
Assembling	80,000	Assembly hours	1600
Machine Maintenance	300,000	Machine hours	10000

XYZ company would use the following formula from ABC costing:

• Overhead rate for purchasing activity (cost pool/cost driver) 

120,000/200= 600

• Overhead rate for assembling activity (cost pool/cost driver) 

80,000/1600= 50

Overhead rate for machine maintenance and overhead rate for production steps would also be calculated in a similar way.

Advantages of Activity Based Costing in Manufacturing Industry

ABC costing is an accounting method used for calculating the total costs involved in the creation or manufacturing of a product. Activity based costing refines the costing system for measuring non-uniformity in the use of resources of an organisation. The key benefits of activity based costing are:

• Activity Based Management

Activity based management develops bases for assigning overhead costs to products. Unlike traditional methods that assigned costs based on machine hours or direct labour costs, activity based costing assigns it according to activities, which are able to generate costs.  

• Traceable Nature of Indirect Costs

Activity based costing makes the nature of different indirect costs including depreciation, utilities and salaries traceable. It also helps raise the unit cost of low volume products. ABC costing further increases the number of cost pools that are required for assembling overhead costs.

• Justification of Overhead Costs

Activity based costing provides a better justification of costs in manufacturing overhead. It also helps find out which processes have wasted costs and determine the profit margin of products with more precision.

• Realistic Cost

ABC costing aside from allocating manufacturing overhead to processes as well as products also offers realistic costs of manufacturing for specific products.

• Non-value Based Activities Included

One of the main elements of activity based costing is adding value to cost processes in such a way  that all forms of non value based activities get eliminated. The entire management gets benefitted from this core feature of activity based costing.

• Statement of Expenditure

Through this costing method, it is also possible to generate statement of expenditure that can further be used for comparing the cost of each activity. With the help of such comparison, it is easier to identify the costs that need to be eliminated and those that need to be improved.

• TQM and BPR

TQM (Total Quality Management) and BPR (Business Process Re-engineering) are useful for the management in adapting approaches that improve the financial performance of company in question. The approach leads to quick and easy determination of transfer pricing, service/product pricing and cost management. It is for this reason that ABC method of costing has also been defined as a productivity improvement approach.

---

Explaining Activity Based Costing Steps in Detail

Activity based costing methodology assigns indirect costs to products/services by finding out the cost of each activity involved in the production process. Therefore, this method also assigns costs to products based on consumption. Steps involved in activity based costing are:

Step 1: Grouping production overheads into activities

When we talk about activities in the context of ABC costing, cost pool is an example ofone such activity created for identifying and allocating production overheads. The words cost pool and activities are thus often used interchangeably. There is a cost driverfor each pool.

Step 2: Identify cost drivers for each activity

Cost drivers impact the level of cost. A good example could be quality control wherein one could find out the very cost of quality control by counting the number of inspections made and the total number of units produced.

Step 3: Calculate Overhead Absorption Rate

In the next step, OAR or Overhead Absorption Rate is calculated for each activity. You can reach OAR by dividing activity cost with information about cost driver. Calculating overhead rate this way allocates overhead rates to each product and service.

Step 4: Absorb the activity costs into the product

In activity based costing, once the overheads are assigned to activities or grouped into cost pools, it is mandatory to relate them or absorb those into cost objects (products and services). The following example would explain this better. Once you are aware about the total number of inspections made on a product, you can easily absorb the corresponding quantity of quality control costs.

Step 5: Calculate profit/loss/production cost per unit

Profit, loss or production cost per unit could be identified by multiplying cost driver with volume of cost driver units. A good example could be multiplying cost per purchase order with the number of orders required per product for a particular month. This would provide profit, loss or production cost per unit of a particular product for that particular month.

FAQs

Summary

Activity based costing allocates overheads by assigning indirect costs to different cost pools. These cost pools are further divided by a cost driver to reach overhead absorption rate. Therefore, organisations, specifically manufacturing units depend on this data or cost set for identifying not just the rate of profit but also determining the sales price.