Activity Based Costing

Activity based costing is a more complete and accurate way of assigning manufacturing costs to a product. It can be used in other ways to determine cost effectiveness, profitability for services rendered and how to estimate per hour billing rates.

First some definitions:

Standard costing – this is the more traditional way of applying overhead costs to products. Anything in the manufacturing process that can’t be easily and directly tied to each product is lumped into manufacturing overhead. To insure products are appropriately prices and accounting for in COGS, the overhead is assigned or allocated to each product using some driver or rate. This typically was labor hours or machine hours.

Direct materials – these are the materials that can be directly tied to the manufacture of a product

Direct labor – the production labor costs that is applied to convert raw materials into a product

Conversion Costs – The sum of direct labor costs and overhead costs. What is necessary in order to convert raw materials into a finished product

Activities – Events or transactions that create costs within a manufacturing entity.

Costs Drivers – an activity that produces costs and which are used to assign costs to products

Unit activities – These activities are performed for each unit of production. These costs vary directly with the number of products produced.

Batch level activities – These activities vary with the number of batches of something. This might be production batches or purchase orders.

Product level activities - These relate to specific products manufactured by the company rather than the units of production. These include parts inventories, engineering change orders

Facility level activities – These relate to the factory level and include factory management, insurance, property taxes, depreciation.