The ABCs of activity-based costing

activity-based costing

As reported on your company’s income statement, revenue and expenses have limited usefulness to people inside the organization. Managers often need information presented differently to make operational and strategic decisions. That’s where activity-based costing comes into play.

The manufacturing and construction sectors commonly use this costing system. The purpose is to determine which products and customers are profitable, to identify and eliminate waste, and to more accurately price products or bid jobs in the future.

Four basic steps to create a cost code

With activity-based costing, you assign cost codes (think of them as price tags) to each activity completed based on the resources consumed. These cost codes define the activity, such as the equipment, materials, and labor used to complete it and how long it takes to finish the task.

1. Identify activities. Create a list of tasks your company performs to complete a job. Then, define each activity so that there’s no overlap between them.

2. Allocate resources. For each activity, list the resources used. These include material, equipment, labor hours, and, if applicable, subcontracting costs.

3. Calculate the per-unit cost of each resource.Choose a standard, measurable unit of each resource and calculate the cost per unit. Sometimes, you’ll have to calculate an average cost based on purchase receipts for a specific period. For example, if a box of screw anchors holds 100 and costs $30, the per-unit cost of screw anchors would be 30 cents if you consider one “unit” to be a single screw anchor. The measurable unit for labor hours would be the wage paid per hour.

4. Determine how much of each resource is used for each activity. Multiply the per-unit cost of each resource by the number of units consumed. Then, add indirect costs to determine the total cost. These may include rents, machinery payments, salaries, and other expenses that don’t directly contribute to completing an activity.

Potential benefits of activity-based costing

Companies can use activity-based costing to learn what’s working — and what’s not. For example, if a job costs more than it should or takes too long to complete. Activity-based costing will quantify for each task: 

  • The materials consumed
  • The pieces of equipment deployed
  • The labor hours spent to complete it

This process allows you to track the progress of jobs in real-time to correct mistakes and inefficiencies before losing money to them.

You also may be able to uncover excessive spending trends to better control purchasing. In other words, it’s strategic planning. The process can provide a clearer picture of what activities and jobs will likely boost the bottom line and enable you to grow your business. Likewise, it can help assess whether your current product mix needs to be modified to increase profits.

Furthermore, estimators can “cut up” a prospective job into well-defined activities with price tags attached to everything. You can then calculate estimates for each task, resulting in a more accurate overall project estimate. In addition, if the scope changes, increasing or decreasing the number of activities, it’s much easier to recalculate the estimate. You can then add or delete activities as line items.

One size doesn’t fit all companies

Activity-based costing can supplement but not replace your company’s traditional cost accounting system. Although this process may seem confusing, software solutions can help shorten the learning curve.

Contact our RRBB accountants and advisors to learn how your business can benefit from activity-based costing and how to effectively implement this process based on the nature of your operations.

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