What is Activity-Based Costing?

How do you currently calculate the cost of the products you sell? Is this done by taking your total overhead and applying that across all the individual products you make or services you perform? The answer to these questions is likely a yes, as this is typically how many businesses build their cost into their pricing structure. This method isn’t wrong, but it isn’t totally accurate, especially if you sell more than one product or service within your business.

Activity-Based Costing, or ABC, is a method used to calculate your overhead costs more precisely for each product or service. Using this method gives you an accurate representation of the expenses associated with the item you are providing. It takes into consideration the time and tools required to complete the job. This cost is then applied to that item instead of a general cost to all things.

Why should I do the extra work for ABC?

Calculating costs is a challenging task for most business owners. There are many components to factor in and lots of math! When you have that initial number, it seems logical to apply that across each item you sell and call it a day. Unless you have only one thing or particular service, money is likely left on the table (and lots of it.) In addition, you could lose out on bids because your cost of an individual item is higher than that of a competitor using an ABC method for calculating their costs. In today’s world of inflation and higher costs of everything, even a few cents can make a difference.

How do I calculate the cost per item?

The best way to understand ABC is to review an actual example. This will allow you to see both methods and make a smart decision for your business. You can take this sample and apply the concepts to your business, whether selling a product or offering a specialized service.

Let’s say you own and operate a local brewery. In that brewery, you specialize in 2 different craft beers provided to your patrons at your local facility. Each beer has a manufacturing method and requires experts (likely you) to create it. There are similar ingredients in all of them, with a few exceptions. The materials and time needed to complete each step, like making the mash, heating, cooling, fermenting, aerating, aging, and packing, are similar but different for each. Breaking down the cost per beer will give you an accurate idea of the cost and how to price it.

Using General Overhead Cost Applied Across all Beers.
Labor & Manufacturing Costs are generalized to include:

Total Manufacturing: $250,000
Total Labor: $125,000
Total: $375,000

This amount is then divided by the volume produced to calculate the cost and determine pricing.
Total Production Volume Per Year: 15,000 Gallons
Cost estimates based on total overhead: $375,000/15,000 gallons = $25 per gallon

Beer 1 (Signature Hazy IPA)
Volume: 7,500 gallons
Cost of Ingredients: $15 per gallon
Overhead Costs: $25 per gallon
Total Product Cost: $40 per gallon

Beer 2 (Bourbon Aged Stout)
Volume: 7,500 gallons
Cost of Ingredients: $30 per gallon
Overhead Costs: $25 per gallon
Total Product Cost: $55 per gallon

This method of calculating cost shows that each beer is charged $25 per gallon in overhead. However, the Bourbon Aged Stout requires specialized equipment and a longer aging process. It must also be kept at a specific temperature, requiring additional electricity and dedicated space. Someone must also monitor it closely, adding labor costs. When you review the individual activities, you find a difference in cost.

Beer 1 (Signature Hazy IPA)
Volume: 7,500 gallons
Cost of Ingredients: $15 per gallon
ABC Cost Calculation: $18 per gallon
Total Product Cost: $33 per gallon

Beer 2 (Bourbon Aged Stout)
Volume: 7,500 gallons
Cost of Ingredients: $30 per gallon
ABC Cost Calculation $29 per gallon
Total Product Cost: $59 per gallon

This detailed breakdown demonstrates that the Bourbon Aged Stout cost is $4.00 more per gallon, and the Signature Hazy IPA is $7.00 less. Each beer would have a price adjustment to stay competitive and maximize profits. The Signature Hazy IPA would be adjusted down slightly, while the Bourbon Aged Stout would slightly increase.

Reach out to an Expert

The one downside of using the ABC method for calculating your cost is the time investment to complete the task. It will take a bit of time to analyze each product or service you do and gather the necessary data to complete the calculations. Working through the process will give you a deeper understanding of your cost per item. Once you have that, you can decide if you maintain an ABC method or continue using a general overhead cost method. Reaching out to experts, like those at Hayes & Associates, can help you determine if this is an accounting method you should pursue.