Pricing products or services is one of the difficult decisions that can either make or break your business. You want to price high enough so you can grow your company with a decent profit margin, but your prices also need to be competitive to get customers through the door.
Many large businesses, particularly in the manufacturing sector, use activity-based costing to help them accurately price their offerings. But, small businesses can also benefit from using this costing method.
Activity-based costing is a complex subject. Learn the basics of what activity-based costing is, how to find it, and how it can help your business.
What is activity-based costing?
The activity-based costing (ABC) system is a method of accounting you can use to find the total cost of activities necessary to make a product. The ABC system assigns costs to each activity that goes into production, such as workers testing a product.
Many businesses use the cost of goods sold (COGS) to determine how much it costs to create a product. But, COGS focuses on direct costs and does not include indirect expenses like overhead.
Some businesses take their overhead expenses and allocate them evenly among all products. But because some products use more overhead expenses than others, the cost of making each product is inaccurate under this method.
With activity-based costing, you take into consideration both the direct and overhead costs of creating each product. You recognize that different products require different indirect expenses. By assigning both direct and overhead expenses to each product, you can more accurately set prices. And, the activity-based costing process shows you which overhead costs you might be able to cut back on.
For example, you make soap. Soap A requires more overhead, like testing, than Soap B. Using activity-based costing, you assign the right overhead costs to the appropriate products. That way, your overhead is higher for Soap A than B.
Activity-based costing steps
To use activity-based costing, you must understand the process for assigning costs to activities.
First, identify which activities are necessary to create a product.
Then, separate each activity into its own cost pool, which is a group of individual costs associated with an activity. Determine the total overhead of each cost pool. For example, purchasing could be its own cost pool.
Next, assign activity cost drivers to each cost pool. Cost drivers are things (e.g., units, hours, parts, etc.) that control the changes in costs. For example, purchasing costs are driven by the number of parts purchased.
Divide the total overhead in each cost pool by the total cost drivers to get your cost driver rate.
Lastly, compute how many hours, parts, units, etc. that the activity used and multiply it by the cost driver rate.
ABC systems can be complicated. Check out this example to help further illustrate the process.
Let’s figure out how much you are spending on utilities to create a product. To do this, you estimate that your total utility bill is $20,000 for the year.
You determine that the cost driver impacting your utility bill is the number of direct labor hours worked. The number of direct labor hours worked totaled 1,000 hours for the year.
Divide your total utility bill by your cost driver (the number of hours worked) to get your cost driver rate. Your overhead application rate is $20 ($20,000 / 1,000 hours).
For this particular product, you used utilities for 3 hours. Multiply the hours by the cost driver rate of $20 to get $60.
How to use the ABC system
Because activity-based costing breaks down the costs that go into creating a product, it has many uses in business.
For small businesses, activity-based costing is great for making overhead decisions and pricing products.
The ABC system shows you how overhead is used, which helps you determine whether certain activities are necessary for production.
If you find that some activities cost more than they should, you can find new methods to do something. Or, you can cut out steps entirely.
The specific allocation of costs also helps you set prices that produce a healthy small business profit margin. If you only know which direct costs go into your products, you are ignoring the other costs, which could lessen your profit margins.
With an ABC system, you can assign costs to each activity in the production process, allowing you to more accurately set a price that accounts for how much it costs you to create a product.
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