Let’s consider a fictional company that manufactures two types of widgets: Widget A and Widget B. The company uses traditional costing methods to allocate its overhead costs based on direct labor hours. However, management suspects that this method is not accurately capturing the true costs of producing each widget type.
To get a clearer picture, the company decides to implement Activity-Based Costing (ABC). They identify the following key activities involved in the production process:
- Material procurement
- Machine setup
- Production
- Quality control
- Packaging
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Now, they assign costs to each activity:
- Material procurement: $50,000
- Machine setup: $40,000
- Production: $100,000
- Quality control: $30,000
- Packaging: $20,000
The company then identifies the cost drivers for each activity:
- Material procurement: Number of purchase orders
- Machine setup: Number of setups
- Production: Machine hours
- Quality control: Number of inspections
- Packaging: Number of packages
After collecting data on the actual usage of cost drivers for each widget type, they find the following:
- Widget A: 100 purchase orders, 80 setups, 1,000 machine hours, 400 inspections, and 800 packages.
- Widget B: 50 purchase orders, 40 setups, 2,000 machine hours, 200 inspections, and 400 packages.
Using ABC, the company can now allocate the costs of each activity to the widget types based on their actual usage:
Widget A:
- Material procurement: $50,000 * (100/150) = $33,333
- Machine setup: $40,000 * (80/120) = $26,667
- Production: $100,000 * (1,000/3,000) = $33,333
- Quality control: $30,000 * (400/600) = $20,000
- Packaging: $20,000 * (800/1,200) = $13,333
Total cost for Widget A: $126,666
Widget B:
- Material procurement: $50,000 * (50/150) = $16,667
- Machine setup: $40,000 * (40/120) = $13,333
- Production: $100,000 * (2,000/3,000) = $66,667
- Quality control: $30,000 * (200/600) = $10,000
- Packaging: $20,000 * (400/1,200) = $6,667
Total cost for Widget B: $113,334
By using Activity-Based Costing, the company can now see that the actual costs associated with producing each widget type are different from what was previously calculated using traditional costing methods. This information can help them make better decisions on pricing, product mix, and resource allocation.
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