MSE608C – Engineering and Financial Cost Analysis Activity Based Costing (ABC)

Activity Based Costing (ABC) The purpose of ABC is to better associate Overhead costs with the product that incur them. It accomplishes this by: defining a number of specific processes with a number of associated activities for each department; measuring the indirect resource costs for each of these activities; determining a cost driver, or output for each process; allocating the costs based on the proportion used by each product.

ABC vs. Traditional Costing Methods ABC allocates Overhead more closely aligned with each product’s consumption of resources. Traditional Methods will tend to over-cost: Products with fewer parts; Larger products; Products built in larger lots; Products with less demanding performance specifications; Standard products. ABC, though, will require more effort and costs to administer and is unfamiliar to most businesses. It can be used in specific Managerial accounting applications for analyzing product costs and improving marketing and sales strategies.

Implementing ABC (cont) Step 1: Identify processes and activities Perform an in-depth analysis of the conversion processes for each department and define activities for these processes. These processes and activities must be clearly defined so raw cost data can be accurately measured. Activity A Process X Activity B Activity C

Implementing ABC (cont) Step 2: Assign costs to activities Indirect resource costs are assigned to the activities. Costs will include: Direct labor Direct material utilities rent depreciation Resource Cost Resource Cost Activity A Resource Cost Process X Activity B Resource Cost Activity C Resource Cost Resource Cost

Implementing ABC (cont) Step 3. Define outputs (cost drivers) Define what the output is for each process in each department. The output will depend on the process. Examples will include: Number of machine setups Machine or labor hours Number of purchase orders placed Number of parts (product complexity) Number of Engineering Change Orders (ECO) Resource Cost Resource Cost Activity A Resource Cost Output Process X Activity A Resource Cost Activity A Resource Cost Resource Cost

Implementing ABC (cont) Step 4. Calculate Unit Cost Unit Cost = Total (budgeted) Activity Costs/Total (budgeted) Cost Driver Used to calculate budgeted Overhead costs; Used to apply Overhead costs to process output. Resource Cost Resource Cost Activity A Resource Cost Output Process X Activity A Resource Cost Activity A Resource Cost Resource Cost

Assessment What are the benefits of ABC? Traditional methods of cost accounting tend to over-cost _______ ? Is ABC allowed to be used for financial reports?