Activity Based Costing (ABC) in an organization is an accounting procedure that most companies use to determine the cost that they involve in producing various products. It is a process that assigns a value to each step and the resources that have been utilized to create that particular product. Different products consume different resources in an organization and ABC aids a company to directly pinpoint some resources that have been spent on specific product. This type of costing is most important to organizations that produce and offer customized products and services to their consumers. Implementing ABC in an organization can become a daunting task, but a customized production allows actual indirect costs to be allocated to a product as compared to other traditional costing methods in use.
In a manufacturing environment or industry, not all costs can be directly apportioned to particular finished goods. ABC has a systematic way of incorporating such overhead costs into the cost allocations. Overhead cost are expenses incurred in an organization which does not directly link to a specific product (The Economist, 2009). Examples of overhead costs include indirect materials, indirect labor and different manufacturing costs that are involved in the production of a product. Manufacturing overhead costs allocation using this method is done more logically as compared to the approaches that were used traditionally. Traditionally, costs were allocated as per the machine hours but using this approach, it is more precise and different. The process involves first identifying the activities that cause the overhead costs. Secondly, it assigns the overall value of those specific activities to the products that consume resources during production (Drury, 2013).
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In comparison to the plant-wide overhead allocation, ABC does not allocate costs to all production process at the same rate. Plant-wide overhead allocation applies a single standard to all processes in the organization that will be accounted to the production output. Cost such as repairs, maintenance, depreciation, electricity, supervision among others is apportioned the same rate to the production or finished goods. ABC does not treat all overhead cost as a cost to all the products produced, but instead, specific products and processes consumed a certain percentage of the overhead costs. In doing so, costs will be identified and apportioned to that particularly finished goods but not to all the goods produced in an organization (Johnson, 2010).
An activity-based costing driver is the number of produced units of a particular process in an organization. Drivers are the leading causes or triggers of an overhead cost in an organization. In most production companies and industries, overhead costs are mostly triggered by the direct labor hours worked to produce a given product, some machine hours consumed, the value of some products returned from customers and among other costs. Such costs are accounted for, and they determine the total amount overhead costs in an organization. In the ABC since it involves apportioning all cost to particularly finished goods, the drivers are critical, and their impact must be involved and adhered to when preparing the total costs of the production processes. In addition to that, a particular product must be allocated its overhead costs and not generalize the value of those drivers (Plank, 2016).
In most organizations and industries that manufacture products, activity-based costing has various benefits. Activity Based Costing method is beneficial in a manufacturing industry because it improves the business processes efficiency. As discussed earlier, overhead costs are allocated according to the cost drivers. Cost drivers are identified in the manufacturing processes, and this gives clarity and exact value on a particular output. It is easier for an organization to know which products are performing better and which are underperforming. Through such an analysis improvement actions will be forged and this will impact on the general performance of an organization. ABC as a method can be beneficial in identifying values that do not add any value to the output and resources can be diverted to improve the best performing and profitable activities. By using ABC, customer satisfaction and turnaround in production processes can be enhanced as well as value addition to the continuous improvement of processes involved in the business (Christopher, 2016).
Likewise, ABC as a cost allocation method aids an organization in identifying the wasteful products that lead to low production outcomes. The costing method allocates cost simultaneously as manufacturing is performed. It allows an organization to monitor and understand where the overhead is consumed. The data obtained from the process is vital to identify unnecessary and wasteful products that contribute to unnecessary costs. Product quality and service delivery in the various methods will eventually be improved because no unnecessary expenditure is spent on wasteful products (Johnson, 2010). Most car manufacturers in the United States firms such as Fiat Chrysler, Ford, Tesla, General Motors and among others have been using the ABC method in monitoring their costs, and their costs have effectively been reduced due to saving on waste. Systematic follow up of each process of manufacturing the car also leads to improving the process and offer the organization decreasing costs.
- Christopher, M. (2016). Logistics & supply chain management. UK: Pearson.
- Drury, C. M. (2013). Management and cost accounting. Springer.
- Johnson, R. (2010). Traditional Costing Vs. Activity-Based Costing.
- Plank, P. (2016). Introduction. In Price and Product-Mix Decisions Under Different Cost Systems (pp. 1-5). Springer Gabler, Wiesbaden.
- The Economist. (2009). Activity Based Costing.