Using activity- based costing to estimate product cost and improve productivity
Sasima Thongsamak
Activity-based costing (ABC) is a new method for calculating the cost of product thereby replacing traditional cost. Give accurate product cost and provides insight information of operation for managers.
For the past two decades, the traditional cost method has failed to provide such accurate costing of products for companies (Tsai, 1995). Traditional cost assigns overhead cost to only one cost driver such as direct labor cost, direct labor hour, direct material. Overhead cost was a small portion of the overall product cost, while nowadays overhead cost tend to takes up a much larger portion.
ABC provides managers with rich information to make better decisions. By allocating overhead costs to activities that the product consumed, activity-based costing provides managers with accurate Cost of products and financial information
Traditional costing lay in the concept that overhead costs can be allocated from one cost driver such as direct labor hour, direct labor cost, and direct material cost. The overhead cost will be calculated by multiplying the direct cost by a mark-up constant, which is assigned by managers depending on their experience. In the past, the traditional costing was adequate because of major two reasons (Andrade et. al, 1999; Cokins, 1999):
(1) The fraction of total product cost due to the direct cost component was substantially larger than overhead component. Therefore, imprecise estimate overhead cost would not cause a big distortion in the cost of product.
(2) Overhead cost component as and is inherently more expensive to determine than the direct cost component. Spending time and money to allocate small amount of overhead would not be worth.
Activity-Based Costing (ABC) requires the execution of the following steps:
To identify firm resources is to identify all direct and indirect costs of operation (e.g., cost of material handling between machine A and machine B). Then these costs will later be attached to specific activities (e.g., material handling). This suggested that mapping firm activities that should be performing at the same time. Activities need to include ones that directly operate to produce products and ones that are indirect such as general management and administrative activities.
The second step, after managers have information of resources and activities, trace those costs from resources to activities to identify cost drivers. Identification of proper cost drivers is one of the greatest challenges of the ABC method (Goldsby, & Closs, 2000).
The third step of ABC method is to trace costs from activities to cost objects. For example, product A requires 20 setups. The cost of driver results from the second step equal $200 per setup. Therefore cost of setup for product A equal to $200x20 setups =$4,000. Four thousand dollars is then assigned to product A for setup activity.
Activities in ABC method can be can be categorized in four types. Each type of activity behaves differently. These four types of activities are (Gunasekaran, & Sarhardi, 1998; Lere, 2000)
(1) Unit-level activities bases, which assume the cost of a unit-level activity changes in direct proportion to change in the number of units produced. Costs are occurred in response to unit-level activities behave like variable costs. Thesame amount of cost must be incurred each time an activity is performed and the same amount of activity must be performed for each unit of a product manufactured.
(2) Batch-level activities bases, which assume that cost of a batch-level activity changes in direct proportion to change in the number of batch produced. Each batch contain different numbers of units, the cost of batch-level activities will vary with the number of batches produced, not the number of unit.
(3) Product-level activities bases, which assume that cost of a product-level activity, is necessary to support the production of each different type of product. The example can be seen in book printing, the correction of an error on a plate is consist to be product-level activity, because this plate will be use in printing books until it wears out, another error was discovered, or books go out of print. Therefore, this type of activity will be assign as product-level activity.
(4) Facility-level activities bases, which associated with providing the capacity necessary to undertake the manufacturing operations, marketing operations, or administration. The examples of these costs are such as depreciation, property taxes, and insurance. These costs behave like fixed costs under the traditional cost behavior classification but be smaller amount compare to traditional fixed costs because they present only the portion that are not vary by unit-level, batch-level, or product-level activities.
Basic benefits for companies that have ABC in place can be summarized below (Gunasekaran, & Singh, 1999; Cooper, 2000):
(1) ABC gives a more accurate product costing. The company then can be aware of the real cost of the product. ABC might reveal the product that company thought was profitable was actually losing money.
(2) ABC provides non-financial information. Besides giving information on a financial basis, ABC gives companies the information on how each activity generates product cost.
(3) ABC encourages improvements. Because ABC provides insight information of operation, managers can see where most of the cost comes from, and how much each activity costs when it is performed and how it relates to certain types of products.
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