Activity-Based Costing: The Necessity To Know The “True” Cost Of A Product

Published by slang November 21st, 2007 in Activity-Based Costing

Unlike other traditional costing systems, one of the importance of activity based costing is to determine the “true” cost for a cost object which is a product, service or customer

Why is then the necessity to know the “true” cost of a product?

Some of the reasons includes the following:

To identify money makers/money losers;
To finding an economic break-even point;
To compare different options;
To discover opportunities for cost improvement;
To prepare and actualize a business plan and
To improve strategic decision making.

Interestingly, the aforesaid “true” products( e.g. total manufacturing costs) have only a minor importance in final market price determination which are more dependent on competitions and customer value.

Append below an illustration of a scenario on both Traditional Cost Accounting and Activity based costing:

Under Traditional Cost Accounting:

Direct Cost:

Product A: requires 1 hour of direct labor

Direct labor cost per hour say:1 x$10/hour=$10

Demand for A =100 units

Product B requires 2 hours of direct labor

Direct labor cost per hour say 2 hours x$10/hour=$20

Demand for B=950 units

Overheads:

Total Overheads=$50,000

Total direct labor=1,000 hours

Overheads per direct labor hour=50,000/1000=$50/hour

Under Traditional Costing System:

Cost For Product A:

Direct cost=$10.00 Total overhead allocation= 1x$50=$50.00

Cost for Product B:

Direct cost=$20.00 Total overhead allocation: 2x$50=$100

Under Activity Based Costing methodology:

Steps as described in earlier article:

Identifying activities
Determine cost for each activity
Determine cost drivers
Collect activity data
Calculate product cost

Identifying activities:
Set-up
Machining
Receiving
Packing
Engineering

Determine cost for each activity:

Set-up$ 5,000
Machining$20,000
Receiving $ 5,000
Packing $ 5,000
Engineering $15,000

Determine cost drivers:

Set-up Number of Setups

Machining Machining Hours

Receiving Number of Receipts

Packing Number of Deliveries

Engineering Engineering Hours

4.Collection Of Activity Data:

Activity	Cost($)	Product A	$	Product B	$
Set-up	5,000	1	1,250	3	3,750
Machining	20,000	100	1,000	1,900	19,000
Receiving	5,000	1	1,250	3	3,750
Packing	5,000	1	1,250	3	3,750
Engineering	15,000	500	7,500	500	15,000
			12,250		45,250

Under Activity-based costing-

Overhead for Product A =$12,250/100=$122.50
Overhead for Product B=$45,250/950 =$ 47.63

Product Costs Results Under TCA & ABC

	Product A	Product B
TCA:
Direct cost	$10.00	$20.00
Overheads	$50.00	$100.00
Total	$60.00	$120.00

ABC:
Direct cost	$ 10.00	$ 20.00
Overheads	$122.50	$ 47.63
Total	$132.50	$ 67.63

Using traditional cost methodology, it looks like Product A has a lower cost than Product B.

However, using ABC, on the contrary, management is able to see clearer that Product A is in fact has a higher cost than Product B.

Conclusion:

ABC is more accurate cost management system than Traditional cost accounting.
Traditional cost account is unable to calculate the “true” cost of a product.

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