Costing: It’s as Simple as ABC– January 12, 2017 by Steve Guarini

Peanut butter. We all love it. After all, who hasn’t spread it on a slice of bread with their favorite jelly? While spreading everything together makes a great PB&J sandwich, when it comes to costing product in a manufacturing environment the “peanut butter” approach of combining everything can have adverse consequences.
In a manufacturing environment, the peanut butter approach is often known as “traditional costing,” whereby overhead costs are assigned to a product based on the volume of a cost driver, such as the machine hours needed to produce an item. However, this methodology, also called production volume based (PVB) cost allocation, fails to:

  1. Allocate non-manufacturing costs associated with production (such as purchasing), and

  2. Recognize that different products can consume vastly different amounts of overhead.

Enter activity-based costing (ABC). This method assigns costs to products or services based on the resources they consume. ABC determines all activities associated with production, assigns a cost to those activities and determines the cost of the product. Because ABC first assigns costs to the activities that are the real cause of the overhead and only to products demanding those activities, it more accurately assigns costs, rather than combining them all together. Further costs not consumed by a product are not allocated since ABC essentially treats overhead costs as direct costs.
Greater costing accuracy is the primary benefit of ABC. Other benefits include:

  • Providing more accurate product and customer profitability information

  • Identifying wasted costs

  • Identifying value-add and non-value-add activities

  • Aiding in competitive product pricing decisions

A simple example of ABC in chart at right illustrates these points. Because overhead is spread evenly using machine hours under the traditional method, even though production is the same for both products, Product A’s unit cost is higher than Product B’s due to the greater number of machine hours used by Product A to achieve the unit output. If we now break out set-up costs, a common distinct “activity” and cost driver, from total overhead using ABC, Product A actually has a lower unit cost than Product B as a result of its lower requirements for setup. In this example, if the company ran a second shift on the machine and could only choose one product to manufacture, it would be picking the less profitable one if it chose Product B (assuming sales prices of both products are the same).
The example only takes into account one cost driver: set-up costs. In reality, overhead costs would be broken down into much more detail and other drivers such as purchasing, packaging, testing, cleaning and maintenance, utilities, etc. would be segregated.
The verdict? Save the peanut butter for a snack and take a look at using ABC to help identify your real costs of manufacturing.

Cohen & Company is not rendering legal, accounting or other professional advice. Any action taken based on information in this blog should be taken only after a detailed review of the specific facts and circumstances.