Activity Based Costing (ABC) or Cost Accounting is a way to divide organization’s fixed costs for products.
“Traditional” way to divide fixed costs is unclear. Should we share costs based on the amount of products produced, the labor hours used per product or by the product prices? All of these will give us very different results so they are not comparable.
Also the labor hours have been descending all the time so using this as an divider is unreliable. Earlier labor hours were major part of the costs but not anymore.
In cost accounting costs are first divided into activities. After that they can be split for products when we know how much these products have caused work on each activity.
Here is an example that is copied from Factory Physics.
Factory produces two products from which A product 6000 units and B product 3000 pieces each month. Fixed costs for the factory is 250 000 €/month. Production runs 5000 hours per month from which A product needs half, 2500 hours and B product another 2500 hours.
So if we divide our costs based on production hours, fixed costs for the product A would be 20,83 €/unit (250 000 € / 5000 h * 2500 h / 6000 pcs) and for the B product 41,67 €/unit. Then we should add also direct material costs in order to have our cost price for product.
If we calculate this with ABC-model we will have totally different result.
Assume we have 4 activities in our company. Activities and overhead costs for them are:
- Requisition – 50 000 €
- Engineering/production – 65 000 €
- Shipping- 35 000 €
- Sales – 100 000 €
Now we can divide these costs into different units that each department uses. 900 purchasing orders have been made in month, 5000 production hours, 9000 products are shipped and 900 sales calls are made. These are divided into products in following ratios:
From the table you can see how different costs are divided. We end up in the result that fixed costs are 25,97 € for A product and 31,39 € per one B product.
Also we can see that this difference comes entirely from the production because other activies are burden with the same 6:3 ratio as production. But production hours are used 2500 hours for both products.
There could be differences in other costs too if in example B product needs more purchased parts. So don’t just divide costs with the same ratio that products are manufactured. You must always calculate how much products are burdening each division.
From this example we can see that ABC will give us much more realistic result than just labor hours. The less labor needed the more distorted result we will have with “traditional” accounting.