An activity’s costs can be allocated to a particular production lot, and this makes activity-based costing an accurate way of allocating both direct and indirect costs. It is a method of computing costs associated with each product or line of production in a company based on the number of resources consumed by each activity. An activity-based costing rate is calculated by assigning indirect costs to a cost pool, adding the costs included in that cost pool together, then dividing the cost pool total by the cost driver. For example, direct labor hours are a driver of most activities in product manufacturing.
If the cost of labor is high, this will increase the cost of producing all company products or services. If the cost of warehousing is high, this will also increase the expenses incurred for product manufacturing or providing services. Product costing is the process of determining the business expenses associated with the manufacture of a product. Using the same expenses and information from Example 1, Rio Group LLC has asked you to allocate its overhead to each product using activity-based costing.
Cost pools are commonly used for the allocation of factory overhead to units of production, as required by several accounting frameworks. They are also used in activity-based costing to allocate costs to activities.
ABC defines production as consisting of a variety of activities, and it assigns costs to those activities. For example, machine set-up might be one activity associated with the production of a particular product.
By calculating the activity-based costing rate for multiple cost pools, a manufacturing company can more accurately determine product cost. For example, in a factory, the number of hours a machine runs determines how much electricity is used and how much will have to be spent on maintenance. In this example, the number of machine hours is the cost driver that controls how much electricity is used and the cost of maintenance. The fewer the number of machine hours, the less the cost of electricity and maintenance; whereas, the higher the number of machine hours, the more the cost of electricity and maintenance. The number of machine hours is a typical cost driver used in traditional costing systems, as is direct labor hours.
Activity-based costing (ABC) is a more accurate way of allocating both direct and indirect costs. ABC calculates the true cost of each product by identifying the amount of resources consumed by a business activity, such as electricity or man hours. Activity-based costing (ABC) is an accounting method that allocates both direct and indirect costs to business activities.
Traditional costing systems are simple, but can result in over-costing or under-costing, as the manufacture of products is generally complex and influenced by more than one cost driver. Activity cost drivers are used in activity-based costing, and they give a more accurate determination of the true cost of business activity by considering the indirect expenses.
In manufacturing, costs not directly assignable to the end product or process are indirect. These may be costs for management, insurance, taxes, or maintenance, for example. Indirect costs are those for activities or services that benefit more than one project.
- Other examples include square footage used per product to allocate factory rent and maintenance and number of purchase orders to allocate purchasing department expenses.
- Activity-based costing systems allow manufacturing companies to more accurately allocate overhead expenses to specific products, as multiple cost drivers are used.
- Like traditional costing systems, machine hours and direct labor hours are typical cost drivers used.
A business that wants to allocate costs at a highly-refined level may choose to do so using a number of cost pools. Indirect costs are, but not necessarily, not directly attributable to a cost object. Indirect costs are typically allocated to a cost object on some basis. In construction, all costs which are required for completion of the installation, but are not directly attributable to the cost object are indirect, such as overhead.
Activity-Based Costing vs. Traditional Methods
The first step would be to group the expenses into different cost pools, depending on the factors that drive the costs. The result will be a dollar amount that can then be multiplied by the number of products manufactured to obtain a total product cost for that cost pool.
Their precise benefits to a specific project are often difficult or impossible to trace. For example, it may be difficult to determine precisely how the activities of the director of an organization benefit a specific project. Indirect costs do not vary substantially within certain production volumes or other indicators of activity, and so they may sometimes be considered to be fixed costs.
The cost of set-up would be one cost included in an activity cost pool. Assigning costs accurately is important to determine the profitability of products and subsequently to make rational production decisions. In a traditional system of accounting, the indirect costs or manufacturing overheads are allocated to the production cost based on a predetermined rate. In some accounting systems, cost drivers are almost irrelevant in determining the contribution. Traditional costing systems allocate manufacturing overhead by dividing total indirect costs by a cost driver to obtain one rate to be used to allocate overhead to different products.
Other examples include square footage used per product to allocate factory rent and maintenance and number of purchase orders to allocate purchasing department expenses. In activity-based costing (ABC), an activity cost driver influences the costs of labor, maintenance, or other variable costs.
What is cost pool and cost driver?
A cost pool is a grouping of individual costs, typically by department or service center. Cost allocations are then made from the cost pool. For example, the cost of the maintenance department is accumulated in a cost pool and then allocated to those departments using its services.
How operating expenses and cost of goods sold differ?
Cost drivers are essential in ABC, a branch of managerial accounting that allocates the indirect costs, or overheads, of an activity. A cost driver is an activity that controls the amount of costs incurred. Labor and materials costs are considered direct costs if they are incurred during the manufacture of a product and can be directly allocated to that product. Manufacturing overhead includes all other expenses incurred during the manufacture of a product that cannot be directly allocated to that product. This might include factory rent, payroll taxes on direct labor wages, and machine maintenance.
Activity-based costing systems allow manufacturing companies to more accurately allocate overhead expenses to specific products, as multiple cost drivers are used. Like traditional costing systems, machine hours and direct labor hours are typical cost drivers used.
Activity Cost Pool
Manufacturing overhead must be accurately allocated to a product’s cost for manufacturing companies to set product sales prices and determine if products are producing profits. A manager may be asked to evaluate production costs of each product produced by a factory. Activity-based costing (ABC) is a common method for determining those production costs.