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Definition of Activity Based Costing

What is Activity Based Costing? How does Activity Based Costing work?

Activity-based costing (ABC) is an accounting technique that enables Crucialtec 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 Crucialtec.

Solving Crucialtec Costing Problem with ABC Accounting Method

Crucialtec markets two types of products in the Electronic Instr. & Controls industry. For sake of simplicity let us call them Technology Standard product and Technology Custom Product. Standard Product is lot simpler than Custom Product, so Crucialtec produces Standard product in large batch sizes compare to Custom product which is produced in smaller batch sizes.

Crucialtec Standard Product	Crucialtec Custom Product
Annual Sales (Units)	12614	12292
Sales Price (Per Unit)	70 USD	84 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	72270	Number of Set Ups
Special part handling cost	60149	Number of Special Parts
Customer invoicing cost	29439	Number of Invoices
Material handling cost	62883	Number of Batches
Other overheads	107319	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 Crucialtec and indirect costs comprise a significant chunk of the overall cost structure of Crucialtec.
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	72270
Special part handling cost	60149
Customer invoicing cost	29439
Material handling cost	62883
Other overheads	107319
Total Overheads (1+2+3+4+5)	332060

To calculate the 'Overhead Recovery Rate' add up all the indirect costs that Crucialtec 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 = 5.93 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)	11.86	14.825
Total Costs Per Unit (1+2+3)	49.86	66.825

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 49.86
The Total Cost per unit of Custom product is 66.825

Return on Sales Calculations for Crucialtec

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	84
Total Cost	49.86	66.825
Profit	20.14	17.175
Return on Sales	28.77	20.446

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 Crucialtec

Activity Based Costing can improve the costing process at Crucialtec 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?

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After identifying all the support activities and associated costs & factors that drive those cost, managers at Crucialtec can take following steps to conduct ABC costing -
Step 1- Establishing Cost Pool for each activity based on the Electronic Instr. & Controls 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	72270	98.729508196721	1184.7540983607	71085.245901639	0.093923743329686	5.7830496177709
Special part handling cost	Special Parts per unit	12614	49168	61782	60149	0.97356835324204	12280.591207795	47868.408792205	0.97356835324204	3.8942734129682
Customer invoicing cost	Invoices per year	50	240	290	29439	101.51379310345	5075.6896551724	24363.310344828	0.40238541740704	1.9820460742619
Material handling cost	Number of Batches	12.614	245.84	258.454	62883	243.30441780742	3069.0419262228	59813.958073777	0.24330441780742	4.8660883561485
Other overheads	Labor Hours	25228	30730	55958	107319	1.9178491011115	48383.497122842	58935.502877158	3.8356982022231	4.7946227527789

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	0.093923743329686	5.7830496177709
Special part handling cost	0.97356835324204	3.8942734129682
Customer invoicing cost	0.4	1.98
Material handling cost	0.24330441780742	4.8660883561485
Other overheads	3.8356982022231	4.7946227527789
Total Overheads	5.55	21.32

The total overheads of standard unit using ABC costing is 5.55 and the overheads of custom unit uning ABC costing method is 21.32

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.

Standard Product	Custom Product
Direct Costs
Labor Hours * Cost of Labor per Hours	16	20
Material	22	32
Indirect Costs
ABC- Overhead	5.55	21.32
Total Costs Per Unit (1+2+3)	43.55	73.32

The Total Cost per unit of Standard product is 43.55
The Total Cost per unit of Custom product is 73.32

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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.

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Return on Sales Using ABC Costing Analysis

Standard Product	Custom Product
USD per Unit	USD per Unit
Selling Price	70	84
Total Cost	43.55	73.32
Profit	26.45	10.68
Return on Sales	37.79	12.714

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 Crucialtec as it stops inefficient allocation of costs to Standard product. Crucialtec 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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