Activity-Based Costing (ABC)
Activity-Based Costing (ABC) is method of allocating overhead costs to the related activities that most specifically drives the manufacturing costs. ABC takes into consideration the activities that generates the relevant costs.In ABC, product and period costs are ignored and instead, the activities that drive the costs are given consideration. ABC is useful in allocating overhead costs by identifying each of the cost-driver activities which are associated with the manufacturing costs.
To better understand how ABC works, let us highlight some of the steps/processes of using ABC.
Steps of ABC
Step 1: Understanding the processes and costs in a plant. This step requires the responsible parties to do extensive research to better understand the processes involved in the manufacturing process. For example, how the raw materials move from one activity base or production stage to the other before becoming finished products.Step 2: Identify activities and costs. In this stage, the management identifies what activities are most relevant to the cost of production. These activities are noted down and their costs are measured and recorded.
Step 3: Calculating, matching and allocating costs to each of the identified activities. After identifying each of the activities and their relevant costs, the final process is to calculate the unit costs of each of the allocated activities and allocating the costs to the relevant overhead costs
To better understand the how ABC works, lets us look at an example of a company that uses ABC to allocate its overhead costs.
Example of ABC Problem - Scenario
PapaGeorge Manufacturers allocates its manufacturing overhead based on the machine hours. During the upcoming year, the company projects to utilize a total of 37,500 machine hours. If PapaGeorge Manufacturers projects to incur a total overhead cost of $750,000 for the upcoming year, how much is the overhead application rate?
Solution - ABC Approach
Overhead application rate = Overhead Costs / Units in the Activity Base
= 750,000/ 37,500
= 20
So the management will use the application rate (20) to find or project the overhead costs to be incurred.