Question

Define Activity Based Cost and its impact on profitbility.

Answer 1

Activity-based Costing which is more popularly known as ABC method is an accounting method in which the firms identify the various activities and then assigns indirect costs incurred to carry out those activities.

The impact of ABC on the costing process is as follows: -

It expands the total number of cost pools and hence is able to assemble overhead costs better and allocate it to particular cost pools.

It alters the nature of various indirect cost and assigns them to various activities for example costs like depreciation, the power consumed, office supplies etc.

Costs are allocated on the basis of activities that generate them instead of another measure of the machine or labour hours.

The main advantage of using the ABC method is its impact on profitability, it helps in improving profitability by streamlining the business process by identifying accurate overhead costs and the reasons for the costs. When all the indirect and direct costs associated with a product are allocated properly it becomes easier for the manager to identify and eliminate wasteful processes. It is best used in manufacturing industry where it increases the profit through a more accurate pricing of the product allowing the companies to offer the various product at more competitive rates.

Example:-

In order to understand the impact of ABC on profitability it is best to look at an example:-

It makes two products A and B.

While B is high volume standardized product A is a specialized and low volume product.

Product A manufactured in a year = 3000 units

Product B manufactured in a year = 7000 units

Total Units manufactured in a year = 10000 units

Let a company has an annual manufacturing overhead as shown below:-

Repair Costs of Parts = $600,000

Machine Maintenance = $400,000

Total Overhead cost = $1,000,000

Let the number of total machine hours used be 10,000 hours

Number of Repairs = 1,000

Machine hours used for product A = 5500

Repairs for Product A = 650

Machine hours used for product B = 10000-5500 = 4500

Repairs for Product B = 350

Traditional Costing Method

Total Overhead cost per product = 1000,000 / 10,000 = $ 100 per product

ABC Based Method

Overhead cost for Product A calculation,

Machine maintenance cost = 400,000 / 10,000= $40

Machine Repair cost = 600,000 / 1000 = $600

So, total maintenance cost used for Product A = 40 * Machine Hours Used = 40 * 5500 =$220,000

So, total Repair cost used for Product A = 60 * Repairs for Product A= 60 * 650 =$390,000

Total Overhead Cost Incurred for A =$220,000 + $ 390,000 = $ 610,000

Hence , Total Overhead cost per unit of A = $ 610,000 / 3,000 = $ 203.33

Overhead cost for Product B calculation,

Machine maintenance cost = 400,000 / 10,000= $40

Machine Repair cost = 600,000 / 1000 = $600

So, total maintenance cost used for Product B = 40 * Machine Hours Used = 40 * 4500 =$180,000

So, total Repair cost used for Product B = 60 * Repairs for Product B= 600 * 350 =$210,000

Total Overhead Cost Incurred for B =$180,000 + $ 210,000 = $ 390,000

Hence , Total Overhead cost per unit of B = $ 390,000 / 7,000 = $ 55.714

So, from the above example, we can see that Product A actually was more expensive to make as compared to Product B. But using the traditional method a cost of $100 was allocated to both the products. So, the example shows ABC can be used to better price the products by assigning a proper cost to each activity, better pricing leads to competitiveness in the market which in turn leads to higher sales and more profitability,