Activity Based Costing Example: Get Control of Your Company Costs

Accounting is an extremely useful tool that can help managers and leaders of businesses figure out just what resources actually cost and where revenues, or income, derive from. In particular, accounting allows a company to really break down its costs, classifying them and then assigning them to various categories, such as direct and indirect expenses Udemy.com provides a very useful training course on accounting for small businesses and managers that covers the many different accounting subjects that people need to know.

One useful accounting method for assigning all a company’s direct as well as indirect costs to proper categories is known as activity based costing. While this term sounds complex, there’s many an activity based costing example and explanation available to illustrate control of your company’s costs.

What an Activity Based Costing Example Actually Explains

Activity based costing is typically seen in various small businesses, especially in manufacturing. By its nature, manufacturing is a production-intensive activity that takes many inputs, processes them in what’s known as a “throughput environment” (i.e. the actual production section), and then disperses them as outputs. Activity based costing, abbreviated in accounting as ABC, takes a manufacturer’s production or manufacturing costs and allocates or assigns those costs in a more precise as well as logical manner.

An activity based costing example is one that assigns manufacturing costs to the actual activities that are the cause of the overhead needed to get products on the market. But there’s an additional step, after a manufacturer’s true overhead is identified – to allocate the overhead only to the manufacturing processes that demand the activities causing the overhead. A workable activity based costing example is what’s known as a “deep dive,” or detailed look at the costs of overhead and the processes that should be assigned those costs.

A Simple Activity Based Costing Example

There’s a simple way to create an activity based costing example by using only two activities, though many manufacturers have ABC examples that account for sometimes hundreds of activities and their cost allocation to hundreds of products. For example, suppose a business makes two products: 1234 and 5678.

Product 1234 is relatively low-volume but does require certain production activities such as special engineering, added product testing and a wide range of machine teardown and setups, because it’s only ordered in small numbers. A machine making Product 1234 can’t sit idle all day once its one hour of 1234-making activities are completed, after all. Chances are, the 1234-making machine will most likely be torn down or reconfigured and then set back up to make another higher-volume product, or even several other low-volume products throughout the production day.

Product 5678, though, is high-volume and the production machines making it run continuously, with such production actually requiring little attention – other than ensuring the 5678-making machines are maintained and don’t break down or interrupt the production process. Also, a high-volume product that is continuously churned out normally doesn’t require any special or added activities, unlike a low-volume product, meaning no machine teardowns and setups and so forth.

In traditional cost accounting, which uses what’s called “machine hours” or the amount of time a machine is run to allocate overhead costs, Product 1234 won’t actually have too many overhead costs assigned to it because its 1234-making machines don’t actually operate much, even though they demanded a great deal of special activities.

Because Product 5678’s machines are running continuously they end up bearing the vast majority of overhead cost allocations, somewhat unfairly, when traditional cost accounting methods are used. To add to the injustice, Product 5678’s machines also used very little in the way of special activities, time, and attention, especially when compared to all the work needed to see to Product 1234’s production output.

Simply, activity based costing overcomes the issue of assigning costs by machine hours by assigning overhead costs more logically through assignment of such costs to more than one activity responsible for operating and maintaining Product 1234’s machines. A working knowledge of basic accounting principles can quickly give any production manager a grasp of overhead costs and their allocation, too, especially when the business is a fresh or new startup. Udemy.com features training that is directly applicable to that need.

The Activity Based Costing Example and the Logical Allocation of Overhead Costs

Traditional cost accounting makes no allowance for special activities such as engineering, testing, machine teardowns and so forth and their specific allocation while an activity based costing example does. Special activities in a production or manufacturing environment cause a company to expend or use resources. Using ABC accounting methods, a company is able to figure out the cost of the resources it’s utilizing in each special activity, such as product testing off the assembly line. Once the cost of resources needed to carry out a product’s special activities are determined they’re then allocated only to the products requiring the activities needed.

Under an activity based costing example, our own manufacturing example’s “Product 1234” widget, say, will be more logically assigned some of the company’s costs of making 1234, rather than simply basing the product’s cost allocation on the number of hours the machines making 1234 are running. In addition, any other products – outside of 1234 – that use the same special activities going into producing Product 1234 will see their own share of overhead costs assigned.

By using activity based costing, Product 1234 will properly bear the majority of costs because it costs more to actually produce 1234, on a per-unit basis, while Product 5678, which requires no special activities, avoids allocation of overhead costs. Cost allocation is vital to a company’s economic health, on both a micro- as well as macro-economic basis, which is why Udemy features a course on how to understand the concepts behind resource allocation, a good first step towards grasping activity based costing.

Why Activity Based Costing Has Grown in Importance

Partly due to inflation, partly due to scarcity of some raw materials as well as several other issues, overhead costs in manufacturing have grown over the last several decades, sometimes by a significant amount. Plus, overhead costs in manufacturing no longer generally correlate to a machine’s actual productive hours or the cost of the labor directly required in creation of a product. Consumers have also become much more demanding and manufacturers, as a result, have greatly increased the number and diversity of products they may offer in a product line.

For example, one model of automobile may have hundreds of variations due to optional equipment, engine sizes and so forth. One car maker, while having seven basic vehicle models, may actually have to produce hundreds of variations across those seven product lines. Finally, some products are simply produced in greater numbers while others are only produced in small batches.

Manufacturers, eager to hold onto every customer they have, will produce surprisingly small numbers of a product. ABC methods are more important than ever in accounting because manufacturers need a much finer level of cost allocation than ever before, if only to finally determine when a product has such a high breakeven point – in terms of the numbers that must be sold to justify the costs of making it – that it really no longer is economically justified in producing that product.

The Activity Based Costing Example and Cost per Unit

Manufacturers always examine the cost per unit made of whatever that unit is that they’re producing. If the cost per unit of something is too high it may be that the product is simply too expensive to justify making it, or its price is too low, or overhead costs have been incorrectly or inordinately assigned to it. Product 5678, for instance, may have an artificially high cost per unit because too many overhead costs are assigned to it when simple machine-hour cost accounting is utilized. Under machine-hour cost allocation a manufacturer, confronted with the high cost per unit of making Product 5678, may decide to either discontinue it or raise its sale price in an attempt to recapture revenue to cover its incorrectly assigned overhead costs.

A higher price for Product 5678 may then cause more customers to stop purchasing it, thus driving its cost per unit, and the breakeven point in terms of the units that need to be sold to not take a loss on its production, higher until the company throws up its hands and halts production altogether.  The activity based costing example, when it’s properly used, would help reduce Product 5678’s cost per unit because it will shift overhead costs to where they belong – in this case, Product 1234.

With a lower cost per unit, the breakeven point for Product 5678, or the number of units of the product that must be sold to not take a loss, will also be reduced. Product 1234, which requires more overhead due to all its special activities, will see it own cost per unit rise and the company will then have a better and more accurate breakeven point.

Taking Advantage of the Activity Based Costing Example

Given the nature of manufacturing in this new millennium, and the diversity of production and products many manufacturers must embrace, the activity based costing example, for lack of a better terms, should always set the example for managers and producers. The ability of a production manager to understand allocation of overhead costs and how it should be logically carried out is vital. If you really want to be a top-flight production manager you need to understand activity based costing, and you can do so by taking advantage of the training Udemy.com offers with various basic accounting tasks.