Functions of Activity-Based Costing Through Variable and Fixed Overhead

When a manufacturer does that occasional bit of bottom-line soul searching, the most fundamental determination to consider is which parts, products, customers, projects, and/or jobs are profitable. To this end, Activity-Based Costing (ABC) is used to identify, assign costs to, and report on manufacturing operations. To a large degree, ABC is a more accurate cost management system than standard cost accounting in that it is able to identify places where the manufacturing process can be made more effective, essentially by determining the "true cost" of producing a product. Shop floor work centers are particularly suitable for ABC because they produce identifiable and measurable units of output. With ABC, management can define processes, identify the cost drivers of those processes, and determine the unit costs of products for performance based budgets that determine the overall cost effectiveness of a work center.
In assigning costs to a work center (a management concept often called cost build-up), work centers are seen as cost centers where costs are analyzed to determine why they occurred. For these purposes, costs are assigned according to their overhead type-variable overhead where the costs are typically consistent per unit (material, labor, labor benefits, and other variables); and, fixed overhead where the total costs are more predictable (machinery, lease payments, utilities, etc.), but the cost per unit is a function of where you can set the volume goal or standard. The setting of a budgeted or standard hours in a work center is very important for pricing purposes and thus will affect how much business you win. If you base your standard volume on too low a number (for example, say 500 hours per year is only 1/8th the hourly capacity of a 2 shift, 5-day a week operation), then your price could be too high to win most jobs. In most cases, it is smarter business to base your fixed cost on a level you would like to achieve, such as 3,000 hours per year (1 ½ shifts). For example, a $40,000 a year fixed cost in a work center will add $80 per hour to the cost of a part based upon a 500 hours per year figure, as compared to $13.33 based upon 3,000 hours standard volume per year.