Activity based costing

[niyati]

I’m trying to understand activity-based costing (ABC) for better cost control in business.
Can someone explain:

• What is ABC in simple terms?
• How it’s different from traditional costing?
• When is it most useful (industries or scenarios)?

Any examples or insights would help. Thanks!

 

[jasminsain]

An organization's activities are identified using the activity-based costing (ABC) technique, which then allocates the cost of each activity to all goods and services depending on how much each is really used. Consequently, in contrast to traditional costing, this approach allocates a greater proportion of indirect expenses (overhead) to direct costs.

 

[jainnorton]

What is ABC in simple terms?

ABC (Activity-Based Costing) assigns overhead costs to products/services based on the actual activities required to produce them, instead of using broad averages. It traces costs to activities (e.g., machine setup, quality checks), then to products that use those activities.

How it’s different from traditional costing?

Traditional costing often uses a single, volume-based cost driver (like direct labor hours) to allocate all overhead. ABC uses multiple cost drivers, reflecting how different products consume different activities, leading to more accurate product costs.

When is it most useful (industries or scenarios)?

ABC is most useful in businesses with:

• High overhead costs: Where indirect costs are a significant portion of total costs.
• Diverse product lines: Products that vary significantly in production complexity, volume, or resource consumption.
• Intense competition: Where accurate product pricing and cost control are crucial.
• Service industries: Like healthcare, financial services, or consulting, where overhead can be complex.

Examples or insights:

Imagine a furniture maker producing simple chairs and complex custom desks. Traditional costing might average overhead, making chairs seem overpriced and desks underpriced. ABC would identify that desks require more design time, specialized machine setups, and quality checks. By allocating those specific activity costs to the desks, the company gets a true picture of profitability for each product. This helps in better pricing and identifying areas for cost reduction.