In case you are looking for a process that will help to improve the overall company profitability, then Activity-Based Costing can be the solution that you might need.
Activity-based costing (ABC) is a specific method of costing calculation that can provide a more accurate understanding of the actual cost of production.
This accurate information can later be utilised to make more informed decisions about resource allocation, product pricing and product mix which later impacts the company’s profitability.
According to the data mentioned in statista, there were 9.93 million job openings in management in the United States in 2023. In this blog, we will take a closure and deeper look at ABC and how through proper implementation it can improve the overall profitability of the company.
Also, the steps that are involved and are necessary for successful implementation. We will explore the benefits which shall help you make a proper decision to USA CMA course to bring career excellence.
What is the Traditional way of costing?
The conventional method of costing calculation that has been utilise for decades is also known as traditional costing.
This sort of conventional method of costing is done by assigning the total cost of production of a product or service based on a single factor, such as machine hours and direct labour.
This implies that the cost of production is directly proportional to the total number of machines or the number of hours of labour required to manufacture it.
Primarily, the traditional method of costing is categorised into two parts which are:
- Direct Cost- These are those costs that possibly can be easily traced to a particular product such as direct labour and cost of raw materials.
- Indirect Cost- These are those costs that are not directly associated with a specific product, such as factory rents, depreciation and utilities.
What is Activity-Based Costing?
Activity-based costing (ABC) is a powerful tool when it comes to improving a company’s profitability of the manufacturer’s products and services through properly allocated costs to them.
The methodology used to determine the true cost of production of a company's products or services helps businesses grow immensely.
It is important to understand the true cost of each activity depending on which managers of that specific organisation can make informed decisions.
These company decisions involve activities that are necessary for producing their products and services that can be eliminated or streamlined for the reduction of manufacturing costs.
It also helps to understand the profitability of their products or services by accurately setting up the cost to them.
This permits managers to identify the most profit-making products or services of that specific organisation and make suitable changes to increase the size of the company and reduce complexity.
Proper implementation of ABC can provide positive outcomes such as increased efficiency, improved decision making and higher profitability for the organisation.
Step-by-step process of Activity-based costing:
The ABC process is a multi-step procedure that requires identification, analysis and assignment of costs to the activities that go to the development of the product or services. Here are the necessary steps required for the proper implementation of ABC:
Step 1: Activities Identification- This is the initial step of implementing ABC to identify all the activities involved in the products or services of that organisation. This can include all the functions, tasks and processes necessary for the development of the product or services.
Step 2: Determination of the Cost Drivers- After the identification of the activities, the next necessary step is to determine the cost driver of each allocated activity. Cost drivers refers to the factors that cause an activity to be performed such as the materials used, number of hours of labour and machine usage.
Step 3: Allocation of cost to Activities- Once the cost drivers are determined then the next step is to allocate cost to each activity based on the cost driver. This implies that the cost driver for a specific activity such as the number of labour, the cost of that activity will be assigned to each product based on the number of labour hours needed to develop it.
Step 4: Calculate Activity-Based Overhead Rates- After assigning costs to each activity, the next step is to calculate the activity-based overhead rates. This involves dividing the total cost of each activity by the total number of cost drivers for that activity.
Step 5: Analyse and Evaluate Results- The final step in implementing ABC is to analyse and evaluate the results. This involves comparing the costs assigned to each product under ABC with the costs assigned under the traditional costing method. This comparison can help identify areas where costs can be reduced or eliminated to improve profitability.
Benefits of implementation Activity-based costing:
There are several benefits of implementing Activity-Based Costing (ABC) in a business and for the purpose of management accounting, including:
- Better Resource Allocation: By identifying the resources required for each activity, ABC can help businesses to allocate their resources more effectively. This can lead to improved efficiency and productivity, as well as reduced costs.
- Improved Customer Profitability Analysis: By identifying the costs associated with each activity, businesses can analyse the profitability of individual customers or customer segments. This information can help businesses to make more informed decisions about which customers to prioritise and which products or services to offer.
- Improved Cost Accuracy: ABC provides a more accurate understanding of the true cost of production by allocating costs to each activity involved in the production process. This information can help businesses to identify areas where costs can be reduced or eliminated, ultimately leading to improved profitability.
- Enhanced Decision-Making: ABC provides more detailed information about the costs associated with each activity, enabling businesses to make more informed decisions about pricing, product mix, and resource allocation.
- Better Cost Control: ABC provides businesses with a more detailed understanding of their costs, enabling them to identify and control costs more effectively.
Activity-Based Costing (ABC) is a valuable tool for businesses looking to improve their profitability. Now that you understand the benefits of implementing ABC in a company, you may be interested in pursuing a career in management accounting.
By completing the CMA course after graduation, you can become a certified management accountant and gain a competitive edge in the job market.