Definition of Activity Based Costing
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What is Activity Based Costing? How does Activity Based Costing work?
Activity-based costing (ABC) is an accounting technique that enables Gati to assign overhead activities costs of the firm to the specific products and services it produces & delivers.
Compare to the traditional technique, ABC assigns the overheads and indirect costs less arbitrarily and focuses on true relationship between costs, overhead activities, and related products (manufactured, produced) / services delivered by Gati.
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Solving Gati Costing Problem with ABC Accounting Method
Gati markets two types of products in the Air Courier industry. For sake of simplicity let us call them Transportation Standard product and Transportation Custom Product. Standard Product is lot simpler than Custom Product, so Gati produces Standard product in large batch sizes compare to Custom product which is produced in smaller batch sizes.
| Gati Standard Product | Gati Custom Product | |
|---|---|---|
| Annual Sales (Units) | 12459 | 12149 |
| Sales Price (Per Unit) | 70 USD | 82 USD |
| Batch Size (units) | 1000 | 50 |
| Direct Labor Time / per unit | 2 | 2.5 |
| Direct Labour rate per hour | 8 | 8 |
| Direct Input cost per unit | 22 | 32 |
| Number of Custom Parts per unit | 1 | 4 |
| Number of Set-Ups per batch | 1 | 3 |
| Separate Material per batch | 1 | 1 |
| Number of Sales Invoices - issued per year | 50 | 240 |
| Overhead Cost Analysis | USD | Cost Drivers |
|---|---|---|
| Set Up Costs | 72736 | Number of Set Ups |
| Special part handling cost | 60679 | Number of Special Parts |
| Customer invoicing cost | 28951 | Number of Invoices |
| Material handling cost | 62979 | Number of Batches |
| Other overheads | 106084 | Labor Hours |
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Solution Based on Traditional Approach of Costing
Traditional Approach - Absorption Approach
The difference between the traditional method and ABC can be only noticed when there are different types of products produced by Gati and indirect costs comprise a significant chunk of the overall cost structure of Gati.
One of the key reasons why small firms still use traditional method is its sheer simplicity. ABC can be highly complex if the firm is present in number of industries and, produce & market various products around firm's core competency.
How direct costs are treated in ABC? Is it different from the way it is treated under traditional approach?
The answer is no difference at all. ABC is concerned only with the way in which overheads are charged to jobs to derive the full cost.
Step 1 - Calculating Overhead Recovery Rate of Indirect Costs
| Overhead Cost Analysis | USD |
|---|---|
| Set Up Costs | 72736 |
| Special part handling cost | 60679 |
| Customer invoicing cost | 28951 |
| Material handling cost | 62979 |
| Other overheads | 106084 |
| Total Overheads (1+2+3+4+5) | 331429 |
To calculate the 'Overhead Recovery Rate' add up all the indirect costs that Gati is incurrring for both the standard and custom product.
Overhead Recovery Rate Formula
Overhead Recovery Rate = Total Overheads / Number of Labor Hours
Overhead Recovery Rate = 5.99 Per Hour
Step 2 - Product / Service Costs - Adding Direct and Indirect Costs
| Standard Product | Custom Product | |
|---|---|---|
| Direct Costs | ||
| Labor Hrs * Labor/hr | 16 | 20 |
| Material | 22 | 32 |
| Indirect Costs | ||
| Overheads (recovery rate * hours) | 11.98 | 14.975 |
| Total Costs Per Unit (1+2+3) | 49.98 | 66.975 |
Using the Overhead Recovery Rate Calculation we can assign the indirect cost to individual products. We are just allocating the variable or indirect costs based on the hours taken by labor to produce the standard and custom products.
Total cost per unit under the traditional method can be calculated by adding up - Raw material costs, labor costs, and indirect cost allocation using Overhead Recovery Rate formula.
The Total Cost per unit of Standard product is 49.98
The Total Cost per unit of Custom product is 66.975
Return on Sales Calculations for Gati
Return on Sales metrics enables the firm to allocate resources where it can maximize returns. After subtracting the cost per unit of the product from sales price of the product we can arrive at the profit per unit.
| Standard Product | Custom Product | |
|---|---|---|
| USD per Unit | USD per Unit | |
| Selling Price | 70 | 82 |
| Total Cost | 49.98 | 66.975 |
| Profit | 20.02 | 15.025 |
| Return on Sales | 28.6 | 18.323 |
The profit per unit of standard product is higher than custom product.In isolation these numbers don't provide a great insight as price is often the function of competitive forces in the market place. To explore further we should analyze - Return on Sales per unit.
Activity Based Costing System for Gati
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Activity Based Costing can improve the costing process at Gati in three prominent ways –
By increasing the number of cost pools – ABC help in identifying the activities that are being performed by organization’s resources. Often too narrow allocation can result in unclear understanding of both activities and how resources spent on them.
By assigning costs to various activities that are segmented based on the role they perform in overall processes. Instead of treating all indirect costs as one organization wide pool, ABC pools the costs based on each activity.
Finally assigning costs to respective products, service and customers activities in the organization using activity cost drivers.
How to calculate Activity Based Costing & What is the formula for Activity Based Costing?
After identifying all the support activities and associated costs & factors that drive those cost, managers at Gati can take following steps to conduct ABC costing -
Step 1- Establishing Cost Pool for each activity based on the Air Courier dynamics.
Step 2 - Allocating total cost associated with each activity to the relevant pool.
Step 3- Calculating Per Unit Cost based on the relevant cost driver.
Step 4 Final Step - Dividing the amount in each pool by estimated total usage of the cost driver. Then the unit cost is multiplied by the number of units of the cost driver of that specific product.
You can easily follow the above four steps in the following table of ABC Calculations.
ABC Calculations
| Overhead Cost | Driver | (a) Standard Diver Volume | (b) Custom Diver Volume | (c) Total Diver Volume a+b | (d) Costs USD | (e) Driver Rate (d/c) | (f) Standard Total Cost a*e | (g) Custom Total Cost b*e | Standard Unit Costs | Custom Unit Costs |
|---|---|---|---|---|---|---|---|---|---|---|
| Set Up Costs | Set-up per Batch | 12 | 720 | 732 | 72736 | 99.366120218579 | 1192.393442623 | 71543.606557377 | 0.095705389086038 | 5.8888473584144 |
| Special part handling cost | Special Parts per unit | 12459 | 48596 | 61055 | 60679 | 0.99384161821309 | 12382.272721317 | 48296.727278683 | 0.99384161821309 | 3.9753664728523 |
| Customer invoicing cost | Invoices per year | 50 | 240 | 290 | 28951 | 99.831034482759 | 4991.5517241379 | 23959.448275862 | 0.4006382313298 | 1.9721333670147 |
| Material handling cost | Number of Batches | 12.459 | 242.98 | 255.439 | 62979 | 246.55201437525 | 3071.7915471013 | 59907.208452899 | 0.24655201437525 | 4.931040287505 |
| Other overheads | Labor Hours | 24918 | 30372.5 | 55290.5 | 106084 | 1.9186659552726 | 47809.318273483 | 58274.681726517 | 3.8373319105452 | 4.7966648881815 |
Per Unit Overhead Cost using ABC
There are two steps to calculate per unit overhead costs using ABC method. First calculate per unit cost based on cost driver usage by specific product and then add those overhead costs for the product to arrive at Per Unit Overhead Cost of a product
| Overhead Unit Cost | Standard | Custom |
|---|---|---|
| Set Up Costs | 0.095705389086038 | 5.8888473584144 |
| Special part handling cost | 0.99384161821309 | 3.9753664728523 |
| Customer invoicing cost | 0.4 | 1.97 |
| Material handling cost | 0.24655201437525 | 4.931040287505 |
| Other overheads | 3.8373319105452 | 4.7966648881815 |
| Total Overheads | 5.57 | 21.56 |
The total overheads of standard unit using ABC costing is 5.57 and the overheads of custom unit uning ABC costing method is 21.56
Total Cost Using ABC Technique
The total cost per unit of standard and custom product can be calculated by adding up - direct cost, raw material cost, and ABC derived per unit indirect cost.
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| Standard Product | Custom Product | |
|---|---|---|
| Direct Costs | ||
| Labor Hours * Cost of Labor per Hours | 16 | 20 |
| Material | 22 | 32 |
| Indirect Costs | ||
| ABC- Overhead | 5.57 | 21.56 |
| Total Costs Per Unit (1+2+3) | 43.57 | 73.56 |
The Total Cost per unit of Standard product is 43.57
The Total Cost per unit of Custom product is 73.56
If we compare the total costs using traditional method and ABC method, we can easily observe that the difference between the total cost of custom product to that of standard product is far higher under ABC method than it is under the tradtional method.
Return on Sales Using ABC Costing Analysis
| Standard Product | Custom Product | |
|---|---|---|
| USD per Unit | USD per Unit | |
| Selling Price | 70 | 82 |
| Total Cost | 43.57 | 73.56 |
| Profit | 26.43 | 8.44 |
| Return on Sales | 37.75 | 10.288 |
The profit per unit of standard product is higher than custom product under ABC technique.By comparing the Return on Sales numbers under both traditional and ABC technique - We can easily conclude that ABC is far more effective costing technique for Gati as it stops inefficient allocation of costs to Standard product. Gati should focus on standard product rather than custom product as standard product is delivering much higher returns on sales.
Limitations of ABC Costing Method
ABC is time consuming and costly.
Setup costs and updating cost for example in the automobile industry is very high and ABC fails to inculcate it.
Business with similar product and services output that require similar activities then the benefits from ABC are very limited.
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