ABC costing focuses on identifying activities, or production processes, that are used to process a job. These individual activities are grouped together with similar processes into a cost pool that relates to single activity cost driver.
The cost pools are then analyzed and assigned a predetermined overhead rate that will eventually be assigned to individual jobs and products.
As you can see, this is a multi-step process, but activity-based costing is a much more accurate way of assigning indirect costs. It’s difficult to determine how much electricity or heat one department or job uses over another without some type of methodical allocation process.
Activity based costing has grown in importance in recent decades because:-
(1) Manufacturing overhead costs have increased significantly,
(2) The manufacturing overhead costs no longer correlate with the productive machine hours or direct labor hours,
(3) The diversity of products and the diversity in customers’ demands have grown, and
(4) Some products are produced in large batches, while others are produced in small batches.
Let’s take a look at an example
Activity based costing helps allocate overhead expenses to jobs and products based on the amount of the activities required to produce the product instead of simply estimating how much each job uses.
Properly assigning indirect costs is extremely important for management, especially in the case of downsizing or outsourcing. Profitable departments can be assigned too much indirect cost causing them to appear unprofitable on paper. Based an evaluation management can choice to discontinue the operations and close a profitable branch because the costs were properly distributed.
To compound the problems, once the profitable branch is closed the only remaining branches are the unprofitable ones. By shutting down the only profitable department, the company may not be able to cover its fixed costs.
The same scenario is true for outsourcing. Management may estimate outsourcing to be a cheaper option because costs have not been allocated properly. In fact, outsourcing might actually be more expensive.