Question

How would you use activity-based costing (ABC) in the organization you work/worked at? Explain activity level in your organization in addition to the steps needed to follow while implementing ABC.

Subject: Managerial Accounting
Write more than 350 words

Answer 1

Activity-based costing (ABC) is a costing methodology that identifies activities in an organization and assigns the cost of each activity with resources to all products and services according to the actual consumption.

ABC approach focuses on cost allocation in operational management. However the challenge is to segregate Fixed Cost, Variable Cost & Overhead cost. Although direct labour and materials are relatively easy to trace directly to products, it is more difficult to directly allocate indirect costs to products. Where products use common resources differently, some sort of weighting is needed in the cost allocation process. The cost driver is a factor that creates or drives the cost of the activity.

Using ABC and implementing the same go hand in hand in any organisation. Once you know that you have complex processes in the organisation and implementing ABC is necessary to identify the costly activities, you need to start allocating the costs of these activities based on product's use. Thus, following steps need to be followed to implement and use ABC in any organisation:

1. Identify costs. The first step in ABC is to identify those costs that we want to allocate. This is the most critical step in the entire process, since we do not want to waste time with an excessively broad project scope. For example, if we want to determine the full cost of a distribution channel, we will identify advertising and warehousing costs related to that channel, but will ignore research costs, since they are related to products, not channels.

2. Load secondary cost pools. Create cost pools for those costs incurred to provide services to other parts of the company, rather than directly supporting a company’s products or services. The contents of secondary cost pools typically include computer services and administrative salaries, and similar costs. These costs are later allocated to other cost pools that more directly relate to products and services. There may be several of these secondary cost pools, depending upon the nature of the costs and how they will be allocated.

3. Load primary cost pools. Create a set of cost pools for those costs more closely aligned with the production of goods or services. It is very common to have separate cost pools for each product line, since costs tend to occur at this level. Such costs can include research and development, advertising, procurement, and distribution.

4. Measure activity drivers. Use a data collection system to collect information about the activity drivers that are used to allocate the costs in secondary cost pools to primary cost pools, as well as to allocate the costs in primary cost pools to cost objects. It can be expensive to accumulate activity driver information, so use activity drivers for which information is already being collected, where possible.

5. Allocate costs in secondary pools to primary pools. Use activity drivers to apportion the costs in the secondary cost pools to the primary cost pools.

6. Charge costs to cost objects. Use an activity driver to allocate the contents of each primary cost pool to cost objects. There will be a separate activity driver for each cost pool. To allocate the costs, divide the total cost in each cost pool by the total amount of activity in the activity driver, to establish the cost per unit of activity. Then allocate the cost per unit to the cost objects, based on their use of the activity driver.

7. Formulate reports. Convert the results of the ABC system into reports for management consumption. For example, if the system was originally designed to accumulate overhead information by geographical sales region, then report on revenues earned in each region, all direct costs, and the overhead derived from the ABC system. This gives management a full cost view of the results generated by each region.

8. Act on the information. The most common management reaction to an ABC report is to reduce the quantity of activity drivers used by each cost object. Doing so should reduce the amount of overhead cost being used.