Understanding Activity Based Costing: Executive MBA

When you are doing your Managerial Accounting course, you surely would have come across the Cost Sheet. Cost Sheet highlights all the various costs that a firm has incurred to produce a good. It may be Direct or Indirect costs. One thing we all know is that Managerial Accounting deals with the internal working of an organisation while Financial Accounting deals with the external. Hence the reports generated by both these departments will differ but eventually tally. Correct me if I'm wrong. 

Traditional vs Activity Based Costing

Traditionally the costing was done on the blanket basis. What that means is that all the cost incurred to produce goods was equally distributed among all the goods. This sounds easier, however, it didn't provide accurate answers. It's like in a class of 100 students, if 20 haven't done their assignment, punishing the entire class isn't right. Similarly blanket costing isn't the apt way to calculate the costs incurred. You cannot track down the resource consumed for one particular type of good.

ABC vs Traditional Accounting. Courtesy: Ozassignments.

So how to overcome this ? Steps Activity Based Accounting [ABC] How ABC differs from existing type of costing is that it takes into consideration the various activities that are performed to produce goods. Say a firm manufactures 2 products - a cricket bat and a football. Both these items pass through a series of activities say Product Design, Procurement, Sales, Logistics and Customer Support. Now if the company's total costs on producing these items are Rs 100,000 then splitting these 50% each on bat and football isn't correct, because the bat may require more procurement in terms of wood while the ball won't require much materials compared to the bat. So Activity Based Costing also considers the units produced of each product along with the rate per unit based on the activity. What this does is that, it ensures that the product which spends more time (more units) in a particular activity, that product will be accounted for more costs rather than the other. 

Thus, Activity Based Costing helps to accurately trace down the costs of a finished good till the last level which ensures fair accounting. I've been trying to understand this concept for a long time now and it wasn't easy. We got assignments in class, and I wasn't quite able to solve them because I didn't understand the basics. However I did practice few numericals on ABC and now understand the process much better. So here too, I'll solve a numerical that will help you understand Activity Based Costing too.

Solved Question - Activity Based Costing

Below is a question that I solved for Activity Based Costing - the simplest one. It did help me understand the concept, I'm sure it will help you too.

The question already provides us with Direct Labor and Direct Materials for each good. Also it has provided the Total Factory Overhead distributed over each activity. 

The first step is to Find the Rate Per Unit of each Activity. For that you can extend the Total  Factory Overhead table and add a new column Rate at the end. Rate is basically the Total Budget for that activity divided by the Estimated Volume (in this case this is provided, usually it is not and this is where people make mistakes). When you do it, you get the following table.

Total Factory Overhead
Activity	Budgeted Overhead	Estimated Volume	Rate
Production Setup	80000	20	4000
Material Handling	70000	5000	14
Pack & Shipping	120000	6000	20
Total Overhead	270000

The Second Step is to prepare the cost sheet and arrive at the cost per unit of each product. Usually the questions are quite twisted and don't give away things this straight forward. They would have some like, the Material Handling rate is 40% of the Direct Labour while Shipping is 50% of Direct Materials and Production is 10% of the Direct Costs. That's where you need to pay attention. 

Considering the Third Table that shows the projected units of each product, we arrive at the final cost sheet. What you have to do is, for each of the activity mentioned, multiply the projected unit with the rate. For instance let's take Computer Parts for Production Setup. The project units for computer parts is 5 (from third table) while the Rate Per Unit for Production Setup is 4000 (calculated above) so we get 20000. Similarly doing same for all the products, we get the following table.

Cost Item	Computer Parts	Cell Phones
Direct Material	120000	34000
Direct Labor	64000	8000
Manufacturing Overhead
Production Setup	20000	60000
Material Handling	14000	210
Pack & Shipping	80000	40000
Total Manufacturing Cost	298000	142210
Total Units Produced	4000	2000
Total Cost Per Unit	74.5	71.105

Last step generally involves coming up with the Cost Per Unit based on Activity Based Costing or Profit (really depends on the question) The case study we worked on - Classic Pens - asked about whether a business decision was feasible or not. 

That's about it on Activity Based Costing. I've understood the concept better - thanks to a little practice. I've mentioned this here hoping that someone will find this helpful at some point of the time. Signing off for tonight.

Cya !