Activity Based Costing Step by step

Traditional cost systems rely on a single volume-based cost driver to allocate overhead, which can lead to distorted product costs if the driver isn't correlated with overhead. This can result in inaccurate pricing and selling products at a loss, a problem exacerbated by increased automation where overhead accounts for a larger proportion of company costs.

ABC identifies activities that cause overhead, groups overhead into cost pools based on activity type, calculates activity rates, and then uses these rates to assign overhead to cost objects like products or customers. This method allocates costs based on cause and effect, unlike the arbitrary single cost driver of traditional systems.

A case study of Santa's toy manufacturing vividly illustrates the difference. Traditional costing, using machine hours as a single driver, showed teddy bears as more expensive. However, ABC, by identifying activities like machine time, inspections, and setups, revealed that dolls were actually more expensive to produce, demonstrating the accuracy benefits of ABC.

ABC offers flexibility in defining product costs for internal decision-making, allowing companies to include non-manufacturing costs (like warranty costs) or exclude certain manufacturing costs if they don't directly relate to specific products. This deviates from GAAP/IFRS rules for external reporting, necessitating two separate cost systems for manufacturers.

Despite its accuracy, not all companies use ABC due to several challenges: the cost of maintaining two cost systems, the time-consuming process of interviewing employees to identify cost pools, potential for employees to overstate time on activities, and the massive amount of data requiring analysis. Implementation can be arduous and face employee resistance.

The video introduces Activity-Based Costing (ABC) as a cost system that measures the cost of providing goods/services, calculates product line profitability, and performs customer profitability analysis. It highlights ABC's superiority over traditional cost systems due to its accuracy.