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May 1, 20203 min read

Activity Based Costing (ABC) - Modern Product Costing Technique

As a result of globalization, customers started having access to more buying opportunities than earlier days. This eventually increased the demand power of customers, pushing manufacturers to offer better quality products & services at a lower price.


Can manufacturers say NO?? Yes, they can but then customers will quickly switch to alternative products & services resulting in a loss of market share. Hence, manufacturers started searching for options to cater customer requirements and be more competitive in the market.


WOW!!! Here comes technology adoption to manufacturing facilities. This resulted in a change in Production Cost Structure.

Remember what we did in absorption costing for traditional manufacturing facilities? If not, refer below link :)

https://osmi-edu.wixsite.com/osmi-edu/post/marginal-costing-absorption-costing

Unlike traditional business in modern business you can't simply consider the total production overhead and absorb using one base. But Why??? You just figured out that production overheads now has a higher portion compared to direct costs and need better analysis for each element.


Let's now see how we are going to deal with this......First you need to understand two terms namely, cost pool and cost driver.


What happens when you are hungry? Such a dumb question as it is obvious that you would eat if you are hungry but the point i want to highlight is what made you to eat....Hunger.....In other words hunger influened you to eat. Eating is the activity you did and hunger is what made you to do the activity.


The same concept will be applied in business world. There will be some influencing factor for every activity we do. In a manufacturing facility, the activities we perform are called cost pool and what influence those activities are called cost drivers. Note that every activity performed requires resources and resource utilization will always have a cost. Hence, a cost will be tagged along with every activity performed in manufacutring.


In Activity Based Costing, instead of absorbing overheads in bulk, you need to absorb each production overhead separately based on the unique influencing factor (cost driver).


Example

Find the unit cost of OS1 and OS2 using the below data.

Step 01 - Identify the Activities

Question has already categorized the set of activities for you (refer column 1 of table 2).


Step 02 - Identify the Cost Driver for Each Activity

Such a lucky moment for you...Question has already given the cost drivers for each activity but in a scenario where no hint of a link to cost drivers given, remember you can choose the most appropriate driver based on available data.


Step 03 - Find the Cost per Driver

This is the rate at which each cost will be absorbed. It is more or less equal to the OAR calculation we did under Absorption Costing but remember now we do this for each overhead element individually. Hence, you cannot call it OAR but Cost Per Driver Rate.

Step 04 - Absorb Overheads to Products

Remember you have absorbed overheads for the total production but not for the unit production. In order to find the unit overhead cost for each product, divide the total overhead absorbed by the number of units.

Oh Gosh!!! Are you wondering how that calculation happened??

Overhead = Cost per Driver Rate * Product Utilization
Example:
Rent Cost for OS1 = $1,150/Sq.ft * 750 Sq.Ft = $862,500

Step 05 - Calculate the Unit Cost













Purindu B Jayatilake

MSc Eng (Reading), MBA, BSc (Hons) Eng, ACMA (UK), CGMA


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