Product & Activity-Based Costing
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Costing systems are information systems. They require a specific type of information such as direct labor hours and units produced, to be of value. It is from the input data that production costs and other information are determined according to the specific costing system defined methodology. The results obtained would depend on the costing system used, since the same input data could be used in different ways. In this case the traditional costing system or an activity-based costing system.
The proper costing ( cost allocation ) is an important but complex topic for any business. This costing topic can get very complex especially in the manufacturing businesses.
The two common costing systems used in business are product-based-costing and activity-based costing.
Product-based-costing assigns manufacturing overhead based on the volume of a cost driver. A cost driver is a factor that causes the cost to incur, such as machine hours, direct labor hours and direct material hours.
Product-based costing provides little flexibility in the way that overhead costs are allocated to finished goods. Even if costs are allocated to products in a weighted fashion based on variable-like cycle time or direct labor, the system is not robust enough to accurately reflect the complicated flow of product in a plant that produces multiple products of different complexity. This can lead to either over-costing or under-costing — allocating too much or too little overhead to an individual product — and can also mask inefficiencies in the production system due to its broad application.
Activity-based-costing allocates the costs of manufacturing a product according to the activities needed to produce the item.
Activity-based costing approaches costs from the perspective that products do not cause costs; they require activities, and the activities themselves are the causes of all costs incurred.
The primary benefit of activity-based costing is that it brings a much higher level of focus and understanding to bear on fixed cost categories. This process will usually involve some form of value-stream or process-flow analysis, which, while time-consuming, will provide invaluable insights into the true drivers of a company’s costs.
The allocation bases used in activity-based costing differ from those used in traditional costing. Activity-based costing determines every activity associated with producing an item and allocates a cost to the activity. The cost assigned to the activity is then assigned to products that require the activity for production.
Why is the costing topic important?
In today’s competitive markets every business wants to have that certain something better / more that makes a difference. As a natural consequence, the costing topic became a more and more important aspect of running the business. Costing translates into the price, therefore, you need to succeed to differentiate your business also through price to be able to survive on the market.
So, should you care? Absolutely YES if you want your business to make it.
Do you need help? I would say YES again, the costing topic has to be done correctly and then it makes a difference.
TopCFO is the place to start the discussions on this topic, we are happy to support you and your finance team because TopCFO is CFO services made easy.
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