Activity-based costing

Activity-based costing

Activity-based costing is an attempt to assess the `true' cost of providing a product or service. Knowledge of the `true' cost is not only important in helping us to identify opportunities for cost improvement but it also helps us to make strategic decisions that are better informed.

Activity-based costing focuses on indirect costs (overheads). It does this by making costs that would traditionally be considered indirect into direct costs. In effect, it traces costs and overhead expenses to an individual cost object. The basic principles of activity-based costing.

Activity-based costing is particularly useful when the overhead costs associated with a particular product are significant and where a number of products are manufactured in different volumes. Activity-based costing is particularly applicable where competition is severe and the margin of selling price over manufacturing cost has to be precisely determined.

The steps required to carry out activity-based costing are:

1. Identify the activities.

2. Determine the cost of each activity.

3. Determine the factors that drive costs.

4. Collect the activity data.

5. Calculate the product cost.

The use of activity-based costing is best illustrated by taking an example.

Example 

Let us assume that APS has decided to go ahead with the production of its new loudspeaker but is also manufacturing a high-quality demountable loudspeaker stand. The company is interested in knowing how these two products compare using activity-based costing.

The activity-based product cost for each loudspeaker amounts to £147,000/3,000 = £49 whilst the activity-based product cost for each stand amounts to £47,000/1,000 = £47. To these two costs we must add the direct (material) costs of each product. Assuming that this amounts to E60 for the loudspeaker and £20 for the demountable stand, we would arrive at a cost of £129 for the loudspeaker and £67 for the stand.

It is worth pointing out that traditional cost accounting would have arrived at two rather different figures for the costs of these two products. Let us assume that 7000 hours of direct labour are used in the manufacture of the loudspeakers and stands. Dividing the total overhead cost of £194,000 by this figure will give us the hourly direct labour cost of £27.71 per hour. If loudspeakers require 2 hours of direct labour and stands require 1.5 hours of direct labour the allocation of costs would be £55.42 per loudspeaker and £41.56 per stand. Adding the same direct (material) costs to this yields a cost of £115.42 for the loudspeaker and £61.56 for the stand.