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What Is Activity-Based Costing?

Determining a price for your business’s products and services is one of the most difficult and data-heavy decisions that you’re likely to make as a business owner. Finding a happy medium between a price that’s high enough to ensure a healthy profit margin and low enough to get customers through your door can be a challenge, which is why so many businesses rely on activity-based costing (ABC). Find out more about ABC costing with our simple guide, including an overview of the advantages and disadvantages of activity-based costing.

Activity-based costing explained

Activity-based costing is a process whereby you can assign operational costs and overheads to the specific products or services that they relate to. It’s mostly used in manufacturing, as it’s much easier to work out the cost of all the activities required to make a certain product in this industry.

Activity-based costing is particularly useful because it recognises the relationship between overheads, costs, and products, giving you the opportunity to assign indirect costs to products in a way that isn’t always possible with more traditional costing methods.

How does ABC costing work?

Now, let’s take a look at how activity-based budgeting works in a little more depth. Here’s a step-by-step guide to ABC costing that should give you more insight into the process:

  1. Firstly, you need to identify all of the activities that contribute to the production of a product. Then, split up these activities into cost pools (an aggregate of all the costs that support a particular task). For example, one cost pool could be customer service, while another could be order processing. It could also be a good idea to have a cost pool marked “other” for costs that don’t fit with the other categories, but nonetheless need to be included.

  2. Now, you should allocate overheads to the different cost pools. In order to determine which overheads are linked to which cost pool, you can either make an estimate or interview your employees for more “boots on the ground” style information.

  3. Next, you need to calculate the activity rate. To do this, divide the total cost associated with each cost pool by the cost driver (i.e. the measurement). For example, for the customer support cost pool, this could be $25,000 in overheads divided by 30,000 customers.

  4. Finally, you can multiply the activity rate by the cost driver to determine the per unit rate, which you can then use to add up all of the total indirect costs associated with all your products/services.

And that, in a nutshell, is how to implement ABC costing. Now, to give you a sense of what this means for your business, let’s take a look at the advantages and disadvantages of activity-based costing.

Advantages and disadvantages of activity-based costing

There are several important benefits associated with activity-based budgeting. Firstly, it gives you a much more accurate overview of product/service costing, which can help you make better decisions around pricing. It provides you with a much more sophisticated understanding of your overheads and cost-drivers and should help you to determine if your business has any costly or non-value adding activities, so that you can take steps to eliminate them.

But what about the disadvantages of activity-based budgeting? While it can be a very effective way to manage your business’s resources, ABC costing may not be especially useful if the overhead only accounts for a small proportion of the overall cost associated with the product or service. It’s also worth remembering that it may be impossible to allocate all of your overall costs to specific activities, and that in some instances, the benefits of ABC costing may not justify the additional expenditure.

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