Activity-based costing is a method of assigning indirect costs to products and services by identifying cost of each activity involved in the production process and assigning these costs to each product based on its consumption of each activity.
Activity-based costing is a more refined approach to costing products and services than the traditional cost allocation methods. It involves the following steps:
- Identification of activities involved in the production process;
- Classification of each activity according to the cost hierarchy (i.e. into unit-level, batch-level, product-level, and facility-level);
- Identification and accumulation of total costs of each activity;
- Identification of the most appropriate cost driver (allocation base) for each activity;
- Calculation of total units of the cost driver relevant to each activity;
- Calculation of the activity rate i.e. the total cost of each activity per unit of its relevant cost driver;
- Application of the cost of each activity to products based on its activity usage by the product.
The first step in activity-based costing involves identifying activities and classifying them according to the cost hierarchy. Cost hierarchy is a framework that classifies activities based the ease at which they are traceable to a product. The levels are (a) unit level, (b) batch level, (c) product level, and (d) facility level.
Unit level activities are activities that are performed on each unit of product. Batch level activities are activities that are performed whenever a batch of the product is produced. Product level activities are activities that are conducted separately for each product. Facility level activities are activities that are conducted at the plant level. The unit-level activities are most easily traceable to products while facility-level activities are least traceable.
Example: Application of Activity-Based Costing
Alex Erwin started Interwood, a niche furniture brand, 10 years ago. He ran the business as a sole proprietorship. While he has 50 skilled carpenters and 5 salespeople on his payroll, he has been taking care of the accounting by himself. Now, he intends to offer 40% of the ownership to public in next couple years and is willing to make changes and has hired you as the management accountant to organize and improve the accounting systems.
Interwood's total budgeted manufacturing overheads cost for the current year is $5,404,639 and budgeted total labor hours are 20,000. Alex has been applying traditional costing method during the whole 10 years period and based the pre-determined overhead rate on total labor hours.
Interwood's sofa range includes the 2-set, 3-set and 6-set options. Platinum Interiors recently placed an order for 150 units of the 6-set type. The order is expected to be delivered in one-month time. Since it is a customized order, Platinum will be billed at cost plus 25%.
You are not a fan of traditional product costing systems. You believe that the benefits of activity-based costing system exceeds its costs, so you sat down with Aaron Mason, the chief engineer, to identify the activities which the firm undertakes in its sofa division. Next, you calculated the total cost that goes into each activity, identified the cost driver that is most relevant to each activity and calculated the activity rate.
The results are summarized below:
|Activity||A (in $)||Relevant Cost Driver||B||C=A/B (in $)|
|Production of components||2,313,132||Machine hours||25,000||93|
|Assembly of components||1,231,312||Number of labor hours||20,000||62|
|Setup costs||34,243||Number of setups||240||143|
|Product testing||24,234||Testing hours||500||48|
Once the order was ready for packaging, Aaron gave you a summary of total cost incurred, and a statement of activities performed (also called the bill of activities) as shown below:
|Order No: 15X2013|
Customer: Platinum Interiors
Type: 6 unit
Amounts in $
|Cost of direct materials||25,000|
|Cost of purchased components||35,000|
|Activity||Relevant Cost Driver||Activity Usage|
|Production of components||Machine hours||320|
|Assembly of components||Number of labor hours||250|
|Setup costs||Number of setups||15|
|Testing Testing hours||22|
Part A: Traditional Costing System
Calculate the total cost of the order and the invoice value of the order based on traditional costing system.
In the traditional costing system, cost equals materials cost plus labor cost plus manufacturing overhead costs charged at the pre-determined overhead rate.
The pre-determined overhead rate based on direct labor hours = $5,404,639/20,000 = $270 per labor hour
The actual number of labor hours spent on the order is 250. Once we have this data, we can estimate the manufacturing overheads and the total cost as follows:
|Manufacturing overheads ($270 × 250)||67,500|
|Total cost under traditional product costing system||143,100|
Interwood bills Platinum at cost plus 25%, so the amount of sales to be booked would amount to $178,875 (= $143,100 × 1.25).
Part B: Calculating Total Cost under Activity-Based Costing
You know activity-based costing is a more refined approach. Now, since you have all the data needed, calculate the order cost using activity-based costing.
In activity-based costing, direct materials cost, cost of purchased components and labor cost remains the same as in traditional product costing. However, the value of manufacturing overheads assigned is more accurately estimated. The following worksheet estimates the manufacturing overhead costs that should be assigned to the order of Platinum Interiors:
|(A)||(B)||(A × B)|
|Activity||Activity Rate||Activity Usage||Activity Cost Assigned|
|Production of components||93||320||29,760|
|Assembly of components||62||250||15,500|
Total cost of the order is hence:
|Total cost under activity-based costing||157,721|
Based on the more accurate estimation of the order cost, the invoice should be raised at $197,150 (=$157,721 × 1.25) instead of $178,875 calculated under traditional product costing system.
The example highlights the importance of correct estimation of the product cost and the usefulness of activity-based costing in achieving that goal. It is because accurate allocation of cost is critical for identification of profitable products and allocating resources.