What is Activity based costing / ABC Costing?

Activity Based Costing / ABC Costing is an important element for Manufacturing companies to arrive at the actual Product Manufacturing Costs. This helps to analyse the cost of production and focus on a specific elements to fix. For example, ABC Analysis contains the below Cost objects and each elements can be analysed to arrive at the problem to fix of activities into cost pools. 

1. Raw Materials Costs / Semi Finished Goods costs. These are direct costs.
2. Labor Costs – Per hour or per Shift costs (These are direct labor hours that are booked on Machine works) – Here you can also define the LABOR COSTS / Activity Cost for ONE Assembly or ONE SHIFT per day.
3. Machines Costs – Per hour or per Shift costs. Few customers also add Pre and Post machine setups hours costs too.
4. Overhead Rate costs – Its mainly related to the management costs and other fixed assets costs. Most of the time, this costs is arrived based on LAST YEARs total OVERHEAD COSTS and that’s divided into the total components produced. While deciding this cost, caution to be exercised.
5. Other costs that needs to be added to arrive at Finished Goods Costs.
6. Subcontract operations payments and how to add this costs to FG / Semi FG products.
7. There are some indirect costs and additional costs to be added to product costs.

Manufacturing industries can have Activity-Based Costing Method elements grouped into different costs of productionlike utilised machine hours, indirect expenses, individual costs of labor and support staffs with above common costs to arrive at the cost per unit of product.

Activity-based costing system helps to arrive at product costing with multiple elements like actual consumption of Raw Materials, Semi Finished goods, Resource costs, other cost centres costs like Projects Departments, manufacturing overhead costs, maintenance cost, overhead costs etc.

These costs helps to define minimum batch size of production on specific machines to reduce costs by activity and operational costs to arrive at the reasonable cost of Finished Products.

Now each of the above cost components and changes in the costs has an impact on the total FG costs. Most of the above costs are added as part of Bill of Materials settings or at Production reporting stages.

ACTouch ERP is a 100% compliant towards ABC Analysis and its costing process. It is an integrated Activity Based Cost Software.

What is ABC Costing?

Activity-Based Costing (ABC) is a costing method that assigns costs to products or services based on the specific activities involved in producing them. Unlike traditional costing methods that allocate costs based on simple volume measures, ABC identifies the various activities within a company and allocates costs to products or services based on the resources consumed by each activity.

For example, consider a bicycle manufacturer. Traditional costing might allocate overhead costs based solely on the number of bicycles produced. However, ABC would identify activities such as materials handling, assembly, and quality control. The costs of each activity, like labor, equipment, and setup time, would then be allocated to the bicycles based on how much each activity contributes to the overall production process.

ABC provides a more accurate cost allocation by reflecting the actual resource consumption associated with each product or service. This is particularly useful when there are diverse products with varying production processes or when overhead costs are not directly tied to production volume. However, ABC can be more complex and time-consuming to implement than traditional costing methods.

In summary, ABC costing allocates costs based on activities, offering a more nuanced view of cost distribution. This approach enhances decision-making by providing a clearer understanding of the true costs associated with different products or services.

Activity-Based Costing Video and it explains in details

How ABC Costing works? Example to understand better

ACTouch ERP follows the method of building Product costs from “Bottom Up” approach. Means, we start from RM price, it’s conversion costs and additional charges, if any to make the SEMI FG Costs (1st level costs).

This Semi FG cost is an input to FG costs. So Semi Finished Goods Costs and the conversion costs like Labor, Machine costs are added to arrive at FG Costs.

Example – To make a FG, we need “ONE Semi FG” and it needs “ONE meter Length of RM”.

RM purchase price is – Rs 100 per meter.

If we use ONE meter of RM to make a Semi FG and the labor costs (Rs 28.00) and Machine conversion costs (Rs 12.50 / component) is added to this RM costs.

The Semi FG cost is = Rs 140.50

Now, we have to make a FG.

For this, we have our labor costs of Rs 29.50 per piece and no machine and other costs.

The FG Costs = Semi FG Costs + FG Labor costs = 140.50 + 29.50 = 170.00

Now, our FG costs includes – RM costs + Semi FGs Labor and Machine costs + FG Labor costs.

This is how the ABC Costing works.

When to use ABC Costing?

ABC Costing method is useful if you have varying Raw Materials costs or change in Labor costs depending on Production Process. Because these are the cost elements that affects the Semi FG / FG costs. Few cases, customer use “Weighted Moving Average Pricing” model.

Few cases, customer uses “Standard Costing” model, where the RM costs is already fixed. The same is true for Semi FG or FG costs as these are already fixed and these includes the LABOR or OTHER COSTS.

Note – It is important to decide on the costing model and follow it. Do not change the pricing model frequently as it will affect your inventory costing and what you show in the Financial Reports.

Difference between Standard Costing vs Activity-Based Costing

1. Definition:

• Standard Costing: Standard costing is a traditional cost accounting method where predetermined standard costs are assigned to products or services. These standard costs are based on historical data, industry averages, and other benchmarks. The actual costs are then compared to the standard costs to identify variances and analyze performance.
• Activity-Based Costing (ABC): Activity-Based Costing is a modern costing approach that assigns costs to products or services based on the activities required to produce them. It recognizes that indirect costs are driven by activities, and it allocates these costs based on the consumption of activities by different products or services.

2. Cost Allocation:

• Standard Costing: Standard costing primarily relies on predetermined costs for direct materials, direct labor, and overhead. Overhead costs are allocated using predetermined rates, often based on a single cost driver, which might not accurately reflect the actual cost drivers.
• Activity-Based Costing: ABC identifies activities that consume resources and assigns costs based on the usage of these activities by products or services. It provides a more accurate and detailed allocation of indirect costs by considering multiple cost drivers that reflect the complexity of production.

3. Cost Accuracy:

• Standard Costing: While standard costing is simple to implement, it may lead to inaccuracies when actual costs deviate from the predetermined standards. Variance analysis helps identify discrepancies, but it might not provide insights into the underlying causes of cost differences.
• Activity-Based Costing: ABC offers greater accuracy by tracing costs to specific activities and cost drivers. It provides a more comprehensive understanding of the sources of costs and enables better decision-making by identifying areas for cost reduction or process improvement.

4. Complexity:

• Standard Costing: Standard costing is simpler to implement and requires less detailed information. It’s suitable for industries with relatively simple production processes and cost structures.
• Activity-Based Costing: ABC involves more complexity due to the identification and measurement of various activities and their relationships with products. It’s beneficial for industries with diverse products, complex production processes, and indirect costs that vary significantly.

5. Cost Control:

• Standard Costing: Standard costing is effective for cost control in industries where cost variations are minimal and easily traceable. It provides a benchmark against which actual costs can be compared.
• Activity-Based Costing: ABC enhances cost control by revealing the true cost drivers and allowing management to focus on activities that have the most impact on costs.

In conclusion, while standard costing is a straightforward approach, activity-based costing offers greater accuracy and insights into cost structure by considering various cost drivers and activities. The choice between these methods depends on the complexity of the business, the level of accuracy required, and the specific needs of cost analysis and control.