Companies are always looking to find a way to decrease cost and maximize profits. There are many ways for companies to cost the way they do things. Activity based costing is just one of those ways. Activity based costing is an accounting method that identifies all activities and the costs associated with these activities; it then assigns the cost associated with the activity directly to the pricing of the output of that activity, rather than averaging the cost across all outputs (Proctor, 2009). Activity based costing helps managers take all the costs of an activity and then be able to price their products.
Activity based costing has been around since the 1980s. When used properly, they can provide managers with more accurate product-cost data that can be used to make more informed decisions about process improvements, pricing, and managing customer relationships (Stout & Propri, 2011). This type of costing allocates fixed costs, variable costs and overhead costs to activities. They help identify cost drivers. There are two purposes to activity based costing. First is to prevent cost distortion and the second is to minimize waste. Cost distortion is prevented by assigning cost drivers. A cost driver is defined as any factor or event that causes a change in the cost of an activity (Raffish and Turney 1991). The cost driver is at the heart of activity-based costing.
Generally, ABC uses four levels in the cost hierarchy: Output unit-level costs (related to the individual units of a product or service); Batch-level costs (related to a group of units); Product (or service)-sustaining costs (related to support a particular product or service without regard to the number of units or batches); and, Facility-sustaining costs (related to costs of activities that cannot be traced to individual products or services). Output unit’level costs are the costs of activities performed on each individual unit of a product or service. Batch-level costs are the costs of activities related to a group of units of a product or service rather than each individual unit of product or service. Product-sustaining costs (service-sustaining costs) are the costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are produced. Facility-sustaining costs are the costs of activities that managers cannot trace to individual products or services but that support the organization as a whole (Horngren, 2015). Activity based costing provides management with a valuable new tool to assist in determining and allocating product costs more realistically. It also provides the means by which to isolate and account for costs in relation to the activities associated with those costs (Lowder, 2006).
To implement activity based costing, the is a seven step approach to follow. The seven steps are:
1. Identify the products that are the chosen cost objects
2. Identify the direct costs of the products
3. Select the activities and cost-allocation bases to use for allocating indirect costs to the products
4. Identify the indirect costs associated with each cost-allocation base
5. Compute the rate per unit of each cost-allocation base
6. Compute the indirect costs allocated to the products
7. Compute the total cost of the products by adding all direct and indirect costs assigned to the products
When managers use activity based costing, they have to decide what level of detail they are going to use. The main costs of using this kind of costing system are the measurement necessary to implement it.
Competition requires companies to continually improve and innovate. New products and services must be developed to replace those that become obsolete. New processes must continually be developed to make production more efficient. But companies globally are realizing that product and service mix was wrongly priced because of the old fashion ‘ traditional accounting systems.