Activity Based Costing, Activity Accounting and Activity Cost Analysis

An activity is (a portion of) a work carried out by a (part of) a company. For each activity Kohler created an activity account (Aiyathurai, Cooper and Sinha, 1991, PP 61-64). An activity account is an income or expense account containing transactions over which an activity supervisor exercises responsibility and control (Kohler, 1952, pp, 18-19). Thus instead of determining the costs of a product, Kohler determined the costs of an activity. On the left side of this account Staubus recorded the costs of the inputs of the activity. These inputs are the outputs from previous activities within the company and / or outputs from another entity (for instance an outside supplier).

Example: Application of Activity-Based Costing

Batch level activities are activities that are performed whenever a batch of the product is produced. Product level activities are activities that are conducted separately for each product. Facility level activities are activities that are conducted at the plant level.

1. A cost driver, also known as an activity driver, is used to refer to an allocation base.
2. Activity-based costing is a system that provides detailed information regarding a company’s production expenditures.
3. The Tennessee Valley Authority was engaged in flood control, navigation, hydro-electric power generation, etc.
4. Now, since you have all the data needed, calculate the order cost using activity-based costing.

What are Batch-Level Activities?

In the traditional costing system, cost equals materials cost plus labor cost plus manufacturing overhead costs charged at the pre-determined overhead rate. Finally, ABC alters the nature of several indirect costs, making costs previously considered indirect—such as depreciation, utilities, or salaries—traceable to certain activities. Alternatively, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products. Under the ABC system, an activity can also be considered as any transaction or event that is a cost driver. A cost driver, also known as an activity driver, is used to refer to an allocation base.

First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. Activities involving a batch of products—as opposed to individual items.

FAR CPA Practice Questions: Capital Account Activity in Pass-through Entities

Activity Based Costing (“ABC”) is an approach to solve the problems of traditional cost management systems which are often unable to determine accurately the actual costs of production and of the costs of related services. Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products. The concept of activity-based costing and, as a consequence, batch-level activity accounting, started in the 1930s. The TVA was in the process of accounting for costs surrounding activities involved with flood control, navigation, and hydro-electric power generation.

The unit-level activities are most easily traceable to products while facility-level activities are least traceable. Activity-based costing (ABC) is a costing method that directly ties all overhead and indirect costs to specific products batch-level activity and services. Second, it creates new bases for assigning overhead costs to items, so costs are allocated based on the activities that generate costs, instead of on volume measures—such as machine hours or direct labor costs. Activity-based costing (ABC) is mostly used in the manufacturing industry. It enhances the reliability of cost data, hence producing nearly true costs and better classifying the costs incurred by the company during its production process.

An example of a batch activity is the setting up of a machine to produce a batch of 1,000 identical items. The example highlights the importance of correct estimation of the product cost and the usefulness of activity-based costing in achieving that goal. It is because accurate allocation of cost is critical for identification of profitable products and allocating resources. Kohler defined an activity as a portion of work done by a specific part of the company. By tracking the costs of such activities in various parts of the company, Kohler began the precedent of accounting for the cost of work activities. Now, since you have all the data needed, calculate the order cost using activity-based costing.

However, these costs are accounted for regardless of the related production run’s size. Examples of these batch-level cost drivers can often include machine setups, maintenance, purchase orders, and quality tests. In an activity-based costing system, batch-level activity costs are allocated to individual products by dividing the total cost of the batch-level activity by the number of units produced in the batch. This allocation helps businesses better understand the true cost of producing each product, which in turn supports more informed decision-making regarding pricing, production planning, and inventory management. This helps managers identify non-value-adding activities and process inefficiencies, and increase profitability.

Kohler found that a traditional form of managerial accounting was not going to suffice in properly and accurately accounting for the costs that were being incurred by the TVA in the process of carrying out their duties. Kohler introduced the concept of accounting for the costs of these processes by accurately assessing the activities involved in carrying them out. Calculate the total cost of the order and the invoice value of the order based on traditional costing system. Activity-based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities. Activity-based costing (ABC) enhances the costing process in three ways.