Benefits & Limitations of Activity-Based Costing

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  • 0:02 What Is Activity-Based…
  • 1:57 Benefits of Using ABC
  • 3:58 Limitations of ABC
  • 4:53 Every Company Is Different
  • 5:35 Lesson Summary
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Lesson Transcript
Instructor: Deborah Schell

Deborah teaches college Accounting and has a master's degree in Educational Technology.

Managers need the best information they can get about product cost so they can accurately determine a product's selling price. In this lesson, you'll learn about activity-based costing (ABC).

What Is Activity-Based Costing (ABC)?

Let's meet Mr. Birch. He owns Birch's Furniture Company, a small company that manufactures hand-made furniture. Mr. Birch recently attended an industry conference and heard about activity-based costing as a way to ensure his costs are more accurate. He wonders if he could use this method for his business to improve costing and generate more profit.

Activity-based costing (ABC) is a method of allocating indirect costs to provide a more accurate total cost of products and services. Indirect costs (also known as manufacturing overhead) are those costs that cannot be traced directly to a product but represent costs such as rent and salaries of supervisors, which are incurred in order to manufacture a product. To calculate an accurate cost for a product, indirect costs must be allocated to each product along with the direct costs of materials and labor used in the manufacturing process. Since product pricing is based on total costs, having a good understanding of manufacturing costs will result in better product pricing and, therefore, higher profits.

ABC uses cost pools to accumulate indirect costs. Cost pools represent individual costs that are influenced by the same cost drivers. Cost drivers are activities that cause the cost of a particular activity to increase. For example, running a machine that cuts wood could be an activity that takes place in Mr. Birch's factory. One of the cost pools in Mr. Birch's company might be equipment maintenance, and the cost driver for this pool could be the number of machine hours that the saw is used. The cost of maintenance would increase as the saw is used for more machine hours. Products that require more cutting and more saw use would be allocated a larger portion of the total equipment maintenance expenses. Cost pools and cost drivers will vary depending on the activities of the business.

Benefits of Using ABC

Using ABC provides management with a better understanding of manufacturing overhead since costs are allocated based on cost drivers and not some arbitrary method. Its use leads to better product pricing since the underlying cost to manufacture a product is more accurate. For example, using an ABC system, Mr. Birch may determine that it costs $250 to manufacture a coffee table, but he is only charging customers $260. Having better cost information would allow Mr. Birch to adjust the price of the coffee table to ensure he's making more profit. Better product pricing leads to greater profits for the company.

Since manufacturing overhead is allocated on the basis of cost drivers versus an arbitrary measure, such as direct labor hours, profitability of product lines and divisions can be determined more accurately leading to better decision making. This is especially important in companies that use more technology than labor to manufacture their products because allocating manufacturing overhead on the basis of direct labor hours worked or direct labor dollars may not make sense.

Let's assume that Mr. Birch currently allocates manufacturing overhead on the basis of direct labor hours. Departments and products that require a large number of direct labor hours would receive a higher share of the manufacturing overhead. This could result in some departments receiving more than their fair share of manufacturing overhead, and in some cases, the product line or division may actually appear unprofitable as a result. By using cost drivers to allocate manufacturing overhead, management can get a better picture of the actual cost of producing a particular product and also its profitability.

Using cost drivers also allows a company to identify business processes that are performing well and those that are not. Management can use this information to ensure resources are directed to those activities that provide value or profit to the company and not to non-valuable activities.

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