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This lesson will help you understand why activity-based costing is used instead of traditional costing and teach you about the seven steps associated with it.
The Move to Activity-Based Costing
The world of manufacturing costs has greatly improved over the last 20 years as companies have moved away from traditional product costing to a more modern and realistic product costing method: activity-based costing (ABC). Activity-based costing is a costing method based on the actual costs to design, manufacture, and sell a product. The company assigns overhead costs, which include direct materials, direct labor, and manufacturing overhead, and indirect overhead that is associated with the manufacturing of the product. ABC also ensures that per item manufacturing costs are more correct.
For example, advertising for a computer made by XYZ, Inc. is an activity attached to the computer. Because of that, it is figured into the cost of the computer, along with the manufacturing costs (direct materials, direct labor, and manufacturing overhead). These three categories of manufacturing costs make up the traditional method of product costing. This method is no longer used because ABC allows companies to more accurately determine the true cost of a product.
ABC allows companies to more accurately determine what the true cost of a product is. This then allows them to correctly price the product to the customer. Proper management of money and knowing the exact amount of that money used to manufacture a product helps the company to remain profitable.
The Seven Steps of ABC
There are seven steps used by companies as they progress through the costing process method of activity-based costing.
1. Identify the products that costs will be defined by.
XYZ, Inc. makes a telephone wire that is used in residential and commercial construction projects to supply data communication services to customers. XYZ is introducing a newer, higher tech version of the telephone wire, Category 6, to its customers and needs to determine how much the wire will cost and how much to charge for it. This new wire, which we will call Cat 6, is the cost object. It is the object that needs a cost assigned to it.
2. Figure out the direct costs of the product.
The direct costs of a product are the costs that can be directly attributed to the manufacturing of a product. As stated earlier, they are:
Direct materials (raw materials and other materials used in the manufacturing process)
Direct labor (the labor costs of the employees manufacturing the product)
Manufacturing overhead (the overhead attached to the manufacturing process, such as electricity at the factory that makes the telephone wire)
The direct costs to manufacture a batch of the Cat 6 are listed in the chart below:
Direct Cost Category
3. Select the activities to use for assigning indirect costs to the products through using a cost-allocation base.
The activities that relate to indirect costs to manufacture a batch of Cat 6 and their cost-allocation bases are listed in the following chart. For this lesson, we will simplify the indirect costs activities as advertising and marketing, administrative, and sales, which you can see in the table below:
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4. Identify the indirect costs connected to each activity of the process.
The indirect costs to manufacture a batch of Cat 6 that are connected to each of the activities from the previous step are listed in the chart below:
Advertising & Marketing
10 hours @ $30 per hour
10 hours @ $50 per hour
24 hours @ $100 per hour
5. Calculate the rate per unit of each activity used to assign indirect costs to the product.
Each batch of Cat 6 contains 100 boxes of Cat 6. Each box contains 1,000 feet of Cat 6. Since XYZ sells the Cat 6 by the 1,000-foot box, we will compute the rate per box for each of the activities associated with indirect costs. Total indirect costs were computed at $3,200 per batch. The percentage rate of cost for indirect costs are calculated by management based on historical data.
Advertising & Marketing
$300 / 100 boxes
$3 per box
$500 / 100 boxes
$5 per box
$2,400 / 100 boxes
$24 per box
6. Calculate the indirect costs assigned to the products.
Cost per Batch
Advertising & Marketing
7. Calculate the total cost of the product by adding all direct and indirect costs assigned to the product.
The total cost to manufacture a batch of Cat 6 is listed in the chart below:
Total Dollar Amount
Activity-based costing (ABC) is the current costing method used in the business world because it allows companies to more accurately determine the true cost of a product. This method replaces the traditional costing method in manufacturing. There are seven steps used to determine the cost of a product in ABC. Each of these steps plays a vital role in helping the company determine the true cost of a product, or cost object, which is the object that needs a cost assigned to it, which will in turn help them more accurately determine product price.
To quickly review, the steps are:
Identify the products that costs will be defined by.
Figure out the direct costs of the product.
Select the activities to use for assigning indirect costs to the products through using a cost-allocation base.
Identify the indirect costs connected to each activity of the process.
Calculate the rate per unit of each activity used to assign indirect costs to the product.
Calculate the indirect costs assigned to the products.
Calculate the total cost of the product by adding all direct and indirect costs assigned to the product.
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