Overview
This lecture explains the basics of activity based costing (ABC) and demonstrates how it helps allocate overhead costs to different products more precisely.
Introduction to Activity Based Costing (ABC)
- ABC stands for activity based costing, a method used to allocate overhead costs.
- ABC focuses on identifying all activities involved in production.
- Overhead costs are assigned to products based on their use of these activities.
Steps in the ABC Process
- First, identify the activities required to make each product (e.g., machine operation, testing, packaging).
- Estimate the total annual cost for each identified activity (e.g., $50,000 for testing).
- Determine the cost driver for each activity, which is the factor that causes the cost (e.g., number of tests).
Calculating Cost Allocation Rates
- Calculate the cost allocation rate by dividing the total activity cost by the total quantity of the cost driver (e.g., $50,000 / 100,000 tests = $0.50 per test).
- Assign costs to products based on how much they use the activity (e.g., basic widget: 1 test; widget pro: 2 tests).
- For each product, multiply the number of activities used by the allocation rate to get the total cost assigned for that activity.
Example: Widget Cost Assignments
- Testing costs $0.50 per test; basic widgets need 1 test ($0.50); widget pros need 2 tests ($1.00).
- In July, 4,000 basic widgets and 2,250 widget pros were tested.
- Total testing cost for July: 4,000 × $0.50 = $2,000 (basic), 2,250 × $1.00 = $2,250 (pro).
Benefits of ABC
- ABC provides a more accurate view of product costs by linking overhead costs to specific activities.
- Managers use these detailed cost assignments for better decision-making.
Key Terms & Definitions
- Activity Based Costing (ABC) — A method that allocates overhead by identifying and assessing activities used in production.
- Overhead Costs — Indirect production costs not directly tied to a single product.
- Cost Driver — A measure that causes or relates to the cost of an activity (e.g., number of tests).
- Cost Allocation Rate — The cost per unit of activity, calculated by dividing total activity cost by total activity driver units.
Action Items / Next Steps
- Review your notes on ABC steps and practice calculating cost allocation rates.
- Be prepared to apply ABC to other manufacturing activities in future exercises.