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Definition of Activity Based Costing

What is Activity Based Costing? How does Activity Based Costing work?

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Activity-based costing (ABC) is an accounting approach that enables Medrx to assign overhead activities costs of the firm to the specific products and services it produces & delivers.
Compare to the traditional approach, ABC assigns the overheads and indirect costs less arbitrarily and focuses on true relationship between costs, overhead activities, and related products (manufactured, produced) / services delivered by Medrx.

Solving Medrx Costing Problem with ABC Accounting Method

Medrx markets two types of products in the Biotechnology & Drugs industry. For sake of simplicity let us call them Healthcare Standard product and Healthcare Custom Product. Standard Product is lot simpler than Custom Product, so Medrx produces Standard product in large batch sizes compare to Custom product which is produced in smaller batch sizes.

Medrx Standard ProductMedrx Custom Product
Annual Sales (Units)1204911877
Sales Price (Per Unit)63 USD81 USD
Batch Size (units)100050
Direct Labor Time / per unit22.5
Direct Labour rate per hour88
Direct Input cost per unit 22 32
Number of Custom Parts per unit1 4
Number of Set-Ups per batch13
Separate Material per batch11
Number of Sales Invoices - issued per year50240
Overhead Cost AnalysisUSDCost Drivers
Set Up Costs72996Number of Set Ups
Special part handling cost60865Number of Special Parts
Customer invoicing cost29400Number of Invoices
Material handling cost62210Number of Batches
Other overheads107256Labor Hours

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Solution Based on Traditional Approach of Costing

Traditional Approach - Absorption Approach
The difference between the traditional method and ABC can be only noticed when there are different types of products produced by Medrx and indirect costs comprise a significant chunk of the overall cost structure of Medrx.
One of the key reasons why small firms still use traditional method is its sheer simplicity. ABC can be highly complex if the firm is present in number of industries and, produce & market various products around firm's core competency.
How direct costs are treated in ABC? Is it different from the way it is treated under traditional approach?
The answer is no difference at all. ABC is concerned only with the way in which overheads are charged to jobs to derive the full cost.

Step 1 - Calculating Overhead Recovery Rate of Indirect Costs

Overhead Cost AnalysisUSD
Set Up Costs72996
Special part handling cost60865
Customer invoicing cost29400
Material handling cost62210
Other overheads107256
Total Overheads (1+2+3+4+5) 332727

To calculate the 'Overhead Recovery Rate' add up all the indirect costs that Medrx is incurrring for both the standard and custom product.

Overhead Recovery Rate Formula

Overhead Recovery Rate = Total Overheads / Number of Labor Hours

Overhead Recovery Rate = 6.19 Per Hour

Step 2 - Product / Service Costs - Adding Direct and Indirect Costs
Standard ProductCustom Product
Direct Costs
Hrs * Labor/hr
Indirect Costs
Overheads (recovery rate * hours) 12.3815.475
Total Costs Per Unit (1+2+3) 50.38 67.475

Using the Overhead Recovery Rate Calculation we can assign the indirect cost to individual products. We are just allocating the variable or indirect costs based on the hours taken by labor to produce the standard and custom products.
Total cost per unit under the traditional method can be calculated by adding up - Raw material costs, labor costs, and indirect cost allocation using Overhead Recovery Rate formula.

The Total Cost per unit of Standard product is 50.38
The Total Cost per unit of Custom product is 67.475

Return on Sales Calculations for Medrx

Return on Sales metrics enables the firm to allocate resources where it can maximize returns. After subtracting the cost per unit of the product from sales price of the product we can arrive at the profit per unit.

Standard ProductCustom Product
USD per UnitUSD per Unit
Selling Price6381
Total Cost50.3867.475
Return on Sales20.0316.698

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The profit per unit of custom product is higher than standard product.In isolation these numbers don't provide a great insight as price is often the function of competitive forces in the market place. To explore further we should analyze - Return on Sales per unit.

Activity Based Costing System for Medrx

Activity Based Costing can improve the costing process at Medrx in three prominent ways –
By increasing the number of cost pools – ABC help in identifying the activities that are being performed by organization’s resources. Often too narrow allocation can result in unclear understanding of both activities and how resources spent on them.
By assigning costs to various activities that are segmented based on the role they perform in overall processes. Instead of treating all indirect costs as one organization wide pool, ABC pools the costs based on each activity.
Finally assigning costs to respective products, service and customers activities in the organization using activity cost drivers.

How to calculate Activity Based Costing & What is the formula for Activity Based Costing?

After identifying all the support activities and associated costs & factors that drive those cost, managers at Medrx can take following steps to conduct ABC costing -
Step 1- Establishing Cost Pool for each activity based on the Biotechnology & Drugs dynamics.
Step 2 - Allocating total cost associated with each activity to the relevant pool.
Step 3- Calculating Per Unit Cost based on the relevant cost driver.
Step 4 Final Step - Dividing the amount in each pool by estimated total usage of the cost driver. Then the unit cost is multiplied by the number of units of the cost driver of that specific product.
You can easily follow the above four steps in the following table of ABC Calculations.

ABC Calculations

Overhead Cost Driver(a) Standard Diver Volume(b) Custom Diver Volume(c) Total Diver Volume a+b(d) Costs USD(e) Driver Rate (d/c)(f) Standard Total Cost a*e(g) Custom Total Cost b*e Standard Unit Costs Custom Unit Costs
Set Up CostsSet-up per Batch127207327299699.721311475411196.655737704971799.3442622950.0993157720727796.0452424233641
Special part handling costSpecial Parts per unit120494750859557608651.02196215390312313.62199237748551.3780076231.0219621539034.0878486156119
Customer invoicing costInvoices per year5024029029400101.379310344835068.965517241424331.0344827590.42069595130232.0485841948942
Material handling costNumber of Batches12.049237.54249.58962210249.249766616323003.2104379659206.789562040.249249766616324.9849953323263
Other overheadsLabor Hours2409829692.553790.51072561.99395804091848050.40087004259205.5991299583.9879160818364.984895102295

Per Unit Overhead Cost using ABC

There are two steps to calculate per unit overhead costs using ABC method. First calculate per unit cost based on cost driver usage by specific product and then add those overhead costs for the product to arrive at Per Unit Overhead Cost of a product

Overhead Unit Cost StandardCustom
Set Up Costs0.099315772072779 6.0452424233641
Special part handling cost1.021962153903 4.0878486156119
Customer invoicing cost0.42 2.05
Material handling cost0.24924976661632 4.9849953323263
Other overheads3.987916081836 4.984895102295
Total Overheads5.78 22.15
The total overheads of standard unit using ABC costing is 5.78 and the overheads of custom unit uning ABC costing method is 22.15

Total Cost Using ABC Technique

The total cost per unit of standard and custom product can be calculated by adding up - direct cost, raw material cost, and ABC derived per unit indirect cost.

Standard ProductCustom Product
Direct Costs
Hours * Cost of Labor per Hours
Indirect Costs
ABC- Overhead 5.7822.15
Total Costs Per Unit
43.78 74.15
The Total Cost per unit of Standard product is 43.78
The Total Cost per unit of Custom product is 74.15

If we compare the total costs using traditional method and ABC method, we can easily observe that the difference between the total cost of custom product to that of standard product is far higher under ABC method than it is under the tradtional method.

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Return on Sales Using ABC Costing Analysis

Standard ProductCustom Product
USD per UnitUSD per Unit
Selling Price6381
Total Cost43.7874.15
Return on Sales30.518.455

The profit per unit of standard product is higher than custom product under ABC technique.By comparing the Return on Sales numbers under both traditional and ABC technique - We can easily conclude that ABC is far more effective costing technique for Medrx as it stops inefficient allocation of costs to Standard product. Medrx should focus on standard product rather than custom product as standard product is delivering much higher returns on sales.

Limitations of ABC Costing Method

ABC is time consuming and costly.
Setup costs and updating cost for example in the automobile industry is very high and ABC fails to inculcate it.
Business with similar product and services output that require similar activities then the benefits from ABC are very limited.

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