What is Activity-Based Costing?
Activity-based costing is an accounting method that assigns costs to the different activities involved in making a product in order to allocate a company’s funds in a fair way. For example, a furniture manufacturer makes two types of chairs. One chair is a straight back kitchen chair with a solid, yet plain design. The other chair is an overstuffed, leather easy chair perfect for a recreation room. An accountant using the activity-based costing system to evaluate the costs for these two chairs would find that the easy chair requires more materials, labor hours, and equipment to manufacture than the straight back chair. Therefore, a greater amount of funds must be allocated toward making the overstuffed chair than the simple kitchen chair.
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The Benefits of Activity-Based Costing
There are several reasons why activity-based costing is preferable to traditional methods of accounting. One of the advantages of activity-based costing is it allows a business owner to see exactly where money needs to be allocated. This method paints a clear picture of the operations of a business.
Another one of the advantages of activity-based costing is that a business owner is able to see where he or she can cut costs. Perhaps this method of accounting reveals that two activities can be combined to save on expenses. Activity-based costing may show a business owner where to direct more resources in order to increase the quality of a product or speed up the manufacturing process.