Implementing Activity Based Costing
Let’s dig into activity based cost allocation. But first, we need to note that not all the allocation methods are based on the “cause and effect” concept. This is important because CEOs and other managers need to know what the real cost of a product or service is. Once that is known, two other considerations need to be addressed:
The first question you need to ask is whether or not on any of the products or services have a negative income (after allocated fixed manufacturing costs). If so, the next question if whether or not eliminating/discontinuing those products or services will result in loss of profit. In other words, is any of your client’s other income a result of carrying that product or service? Or is there some other product or service that can replace that income source and increase profitability? If so, then eliminate the product or service so that you can increase the overall profitability.
If the answer is “no,” then you need to take a different approach. This approach involves assigning/allocating costs based on the ability to bear costs or some other equitable method. The goal for these methods is to keep the Board happy; so, the firm does not show any products or services that are losing money. In addition, these methods need to find another way to maximize profit by incentivizing the sales staff to sell certain products. Accomplish this by allocating overhead in such a way that each sales person’s bonus or commission is tied to the products or services that maximize profit for the firm.
The most common approach used to allocate overhead (and joint costs) equitably is the relative sales value approach. It allocates overhead to products based on overall sales value. This approach works best in situations such as a full service hardware store that offers lumber, equipment and garden supplies. Chances are in a situation of that nature that the garden supply area would either break even or lose money if only based on its “cause and effect” share of overhead. Chances are that that department also contributes to the profitability of the other departments.
As a result, allocating the building overhead based on total revenues of each department would enhance the perceived profitability of the garden supplies department. Thus, your Board would be happy. Your CEO wouldn’t constantly explain that overhead is an allocated fixed cost. All that matters is overall profitability. Over, and over, and over again.