Activity based costing involves assigning costs to each of the products or services of a business based on the financial resources that are used to create a particular product or service. The financial resources used to create a product or service includes wages, rent, supply costs, and other costs.
Activity Based Costing Video Tutorial With Examples
The reason why ABC or activity based costing is used is to get a better picture on the profitability of a particular product. An ABC costing analysis often shows surprising results; a company may not be aware that one of their products or services is substantially more profitable than another.
Traditional cost accounting does not provide as detailed of a picture of the direct costs that a specific product or service costs a business. ABC shows a business their return on investment and products or services that they should spend more of their resources on promoting.
It can help a business determine which products and services it should get rid of, deciding between outsourcing or using in-house employees, evaluating product improvement efforts, and more. ABC is commonly used in the manufacturing industry and less commonly used in the financial services sector and the public sector.
Activity Based Costing Video Example 1
Activity Based Costing Video Example 2
Activity Based Costing Written Example
Suppose that an ice cream store sold two main products: ice cream cones and milkshakes. The store owner has a rent expense for his location, and the expense includes electricity and water service. Since the milkshakes require much more electricity to produce due to having to use a blender sink and dishwasher, it is estimated that the milkshakes use up about 60% of the rent cost, while the ice cream cones are simpler to produce and only use 40% of the rent cost.
If the monthly rent is $1,000, $600 of the rent is allocated to the milkshakes and $400 is allocated to the ice cream cones. Customers who purchase ice cream cones also get two napkins while milkshake customers do not ask for napkins, so the full monthly napkin supply cost of $200 will be allocated to the ice cream cones. Milkshake customers need a cup and straw, and the full monthly cost of $400 for the store’s cups and straws would be allocated to the milkshakes.
For employee wages, the store owner hires one employee at a cost of $5,000 per month. When determining the percentage of monthly wages that are allocated to each product, you would look at the number of steps required to create each product. Ice cream cones are created in two steps, while milkshakes take five steps to create. These steps are called cost drivers.
Say the store sells an average of 1,000 ice cream cones and 1,000 milkshakes each month.
So, it takes 2,000 steps (2 x 1,000) to create the ice cream cones and 5,000 steps (5 x 1,000) to create the milkshakes. The total number of steps for each month is 7,000.
To determine the percentage of wages that should be allocated to the ice cream cones, you simply take 2,000 (the steps needed to create the ice cream cones each month) / 7,000 (the total number of steps each month). The result is 0.2857 or 28.57%.
To calculate the wage cost to create the ice cream cones, take 28.57% of $5,000 (the monthly wage cost for the employee) which is $1,428.57.
The same formula is used to calculate the wage cost for the milkshakes. 5,000 / 7,000 is 0.7143 or 71.43%. To calculate the wage cost to create the milkshakes, take 71.43% of $5,000 which is $3,571.43.
Of course you could have subtracted $1,428.57 from $5,000 to arrive at this number as well, but this is a simplified example. Most companies have several products or services that they need to include in their calculations, and the financial resource calculations are also usually much more complicated.