What is Cost Accounting?

Cost Accounting is a form of managerial accounting that helps the company in assessing the total variable cost so as to compute the cost of production. Cost accounting is generally used by the management so as to ensure better decision-making. In comparison to financial accounting, cost accounting has to follow a set standard ad can be used flexibly by the management as per their needs. The types of Cost Accounting include – Lean Accounting, Standard Costing, Marginal Costing and Activity Based Costing.

Activity-Based Costing (ABC)

Activity-based costing (ABC) is a costing method wherein the overhead and indirect costs are assigned directly to those products and services which is related to it. As compared to the traditional method of costing, activity-based costing helps in assigning indirect costs to products in a much convenient manner. The activity-based costing (ABC) method is generally used in the manufacturing industry thereby helping to identify and allocate the costs that the company incurred during its production process. However, there are some indirect costs such as management and office staff salaries which are difficult to assign to a particular product. The activity-based costing (ABC) method also helps companies to enhance their pricing strategy.

What is Cost Pool and Cost Driver?

A cost pool is generally a group of individual cost from which the cost allocations are done to the concerned department. The cost pools are commonly used for assigning factory overheads to the units of production and also in activity-based costing to allocate costs to the concerned activities.

A cost driver on the other hand is defined as a factor that causes a change in the cost of an activity. It generally determines the cost behaviors within an activity. They help in establishing a link between the activities and the cost of product. 

Activity Cost-Driver in ABC

The cost drivers help to allocate manufacturing overheads in a much-simplified manner. It influences business activities thereby resulting in the increase or decrease of the activity costs. The machine hours, direct labour hours, etc. helps the business owner in estimating the true cost of production. This method of costing is mostly put to use for calculating the amount of indirect and overhead costs related to a particular activity. The cost driver rate is calculated by dividing the total pool cost. However, its selection has not been mandated by any industry standards so far. 

Overheads

The overhead refers to the cost which is incurred in operating an ongoing business. The overheads can be fixed, variable, or semi-variable. It is a general expense which the accountants allocate to the income statement thereby affecting the overall profitability of the company. The overheads are generally accumulated as a lump sum further which the cost accountants allocate to a specific project based on cost drivers. This allocation helps in improving the different ongoing operations of the company.

Different kinds of overhead expenses are incurred namely:

●       General and Administrative overheads

●       Selling and Distribution overheads

●       Manufacturing overheads

●       Research overheads, etc.

Calculating Overheads

The overhead being a general expense is first accumulated as a lump sum and then allocated to a particular product or service. The formula for calculating overhead rate is:

Overhead Rate = Indirect Costs ÷ Allocation measure.

The allocation measure is the procedure by which the production in a company is measured like labor hours, direct machine costs.

For example: In a case where $10,000 is allocated for setting up 4,000 machines. The cost driver rate will be ($10,000 ÷ 4000) = $2.50. Now, if in the case out of 4000 machines, 200 machines were assigned to produce Product ABC. So, the overhead cost for Product ABC will be ($2.5 × 200 = $500.)

Advantages of Activity Based Costing (ABC)

• Accurate Product Cost: This method of costing helps to bring about accuracy and reliability in the cost of a product by ascertaining the cause which led to such incurrence of cost. It helps in determining that it is the activities wherein maximum costs are incurred.
• Information about cost behavior: The activity-based costing system helps in reducing the cost of a product and identifying those activities which hardly add any value to the product. Under the ABC system of costing the managers at different levels keeps a check on the fixed overhead costs which are incurred during the production.
• Tracing activities for the cost object: The multiple cost drivers helps the ABC system in tracing overhead costs, allocation of which is done to the products.
• Better decision making: The activity-based costing system helps in providing reliable data related to product cost, which enables a manager to make better decisions with regards to fixing the selling prices of the products.
• Use of excess capacity and cost reduction: The activity-based costing method helps in the identification of the spare capacity thereby enabling a reduction in the costs and projecting the future resource requirements by the management of the company.
• A benefit to the service industry: As most of the service organizations like banks, hospitals, etc. incur more overhead costs than direct costs, so in that the activity-based costing system helps these organizations to improve their decision making and management as far as the costs are concerned and allocate them appropriately.

Disadvantages of Activity-Based Costing (ABC) System

• Expensive and Complex Under this costing system as multiple cost drivers are involved; it makes this system very complex than traditional costing systems and a bit more expensive with regards to its management.
• Selection of drivers: The selection of appropriate drivers amongst many, rapidly changing cost driver rates and the proper allocation of overhead costs are some of the difficulties which make the ABC system very different from traditional costing systems.
• A disadvantageous to smaller firms: The activity-based costing system helps to properly allocate product costs and function to provide its overall accuracy, however, it is only suitable to large manufacturing firms and not the ones who used market-based prices to determine their costs.
• Difficulty in measurement: The activity-based costing system requires numerous amounts of calculations for cost determination of products and services and the measurement which is used for such determination is very costly and cumbersome. 

Step-by-Step Procedure Which Helps in Calculating Activity-Based Costing (ABC)

1. First, all the activities are identified which will help in creating a product.
2. The cost accountants assign each activity to a product line.
3. After the assignment, total overheads for each cost pool are calculated. A cost pool is a group of individual costs which comprise an activity.
4. Thereafter, the concerned department assigns activity cost drivers to each group under the ABC method.
5. The cost driver rate is then figured out, which is then multiplied with the amount of activity cost drivers to arrive at activity-based costing.

Formulas

Activity-Based Costing (ABC) = (Overhead for cost pool ÷ Cost drivers) × Amount of activity cost drivers.

Context and Applications

• The ABC helps in tracking whether the activity costs are following the industry standards or not.
• The activity-based costing (ABC) helps in bifurcating the additional overhead costs and enables the management to identify which customers are earning them maximum profits, as a result, the unprofitable customers are done away with by the management.
• The proper allocation of overhead costs under the ABC system helps the company to identify the margins on various products and helps the management in deciding which company resources should be used to earn the highest margins.
• The ABC system also helps in determining the minimum price at which the product should be sold in the market by allocating required overhead costs to a minimum cost of the product.