Implementing Activity Based Costing
All of us have used cost allocation, the process of assigning common costs to ending inventory and cost of goods sold (COGS), as part of our Financial Services offerings since it is required by GAAP. Our goal has been to either reduce taxes or increase reported earnings, depending on our client’s needs and circumstances. But what about cost allocation’s other uses? Are we shortchanging our clients by not offering services in this area (usually referred to as cost or management accounting services)? In this wiki, we will explain how to go about implementing activity based costing.
Other Uses for Cost Allocation
Managers’ use cost allocation for a number of reasons. First and foremost, cost allocation provides a methodology for assigning overhead costs of various activities, usually support departments, to products or services being produced and/or sold allowing upper management to assess and analyze their profitability. By knowing what the true “cause-and-effect” relationship is, managers are able to more accurately assess the true cost of a product/service. They can determine if carrying certain products/services contributes to overall profitability given the demand and price sold for.
This is especially important as it pertains to both operational decisions. Operational decisions include:
- Calculating the maximum price a firm can charge, especially for a “commodity” product
- Determining the maximum cost a firm is willing to pay to provide this product or service
- Making special order and transfer pricing decisions
- Capital/long-term decisions (such as make-or-buy component decisions, continue or discontinue a product line decisions, process further decisions, etc,)
Cost allocation can also be used to reduce wasteful spending and/or promote more efficient use of resources (especially PP&E) by evaluating needs and uses for the year to come as part of the planning/budgeting process. Managers can then be evaluated on their planning effectiveness, leading to better communication, sharing of resources, and cost efficiency. They can also use it to manage product and process design. As allocations are broken down/determined, the use of resources becomes transparent from a process standpoint, allowing managers to improve operations as needed.
[button link=”https://strategiccfo.com/scfo-lab-sl?utm_source=wiki&utm_medium=button%20cta” bg_color=”#eb6500″]Learn About The SCFO Lab[/button]
Traditional Cost Allocation
Prior to the advent of computers, one based the traditional method of allocating overhead costs on a single volume-based allocation base or cost-driver. Unfortunately, volume-based costing allocated overhead using one allocation base that may or may not have had a “cause and effect” relationship to the costs being allocated to the product or service. For example, suppose a manufacturing firm had two production departments – one that used a large labor force with few pieces of equipment and one that was predominantly machine driven. Allocating Personnel or janitorial costs on the basis of machine hours would be very inefficient. By the same token, allocating maintenance costs and building costs to products or services based on direct labor costs would be equally inaccurate.
Fortunately for both our clients and our firms, a better method of cost allocation was developed: Activity Based Costing (ABC) thus allowing overhead costs to be more accurately allocated to products. The purpose of allocation at that time was merely to put a price on inventory for reporting purposes.
Activity Based Costing allocates costs based on multiple cost pools (activities or department budgets) each with its own appropriate (“cause and effect”) cost drivers. This leads to more accurate costing and improved control over overhead costs. Activity based costing is especially effective when a firm has a highly diverse or heterogeneous product or service mix, when overhead costs account for much of the total costs, and in situations where the manufacturing process is capital/PP&E-intensive.
Clients need help identifying cost pools and their appropriate cost drivers (allocation bases). Then they need help calculating the overhead costs to be assigned to production departments and, ultimately, to the final service or product. Since this is time consuming and requires a certain amount of skill, it can be expensive to implement. It is especially expensive if not done properly. You can help your client in this area.
Implementing Activity Based Costing
The steps involved in activity based costing are:
1) Clarify the purpose of the allocation, defining why the need to allocate these costs exists and defining the benefit of doing so.
2) Identify support and operating department cost pools;
3) Select an allocation base or cost driver for each support department cost pool based on a cause-and-effect relationship between the support departments and the operating/production departments.
4) Choose and apply a method for allocating support department costs to operating/production departments. The three most widely used methods include the following:
- Direct method
- Step-down method
- Reciprocal method
We will discuss them shortly.
5) Once the allocation of support costs to the operating departments is complete, cost drivers are selected for the newly formed cost pools (production/operating department overhead costs) and costs are then allocated to the units of goods or services.
Direct Method of Allocation
Before we continue, it would be good to discuss the three methods discussed in step 4. The direct method allocates costs directly from the support departments to the operating departments that use its services. For example, the personnel department might allocate its overhead (i.e., ALL of its departmental costs) based on the number of employees in each of the operating or production departments. It is a simple method that only considers the total cost drivers in the operating departments. Continuing with this example, personnel department costs would be allocated 100% based on 100% of the employees in the operating departments with no regard to those employed in personnel, maintenance, engineering, service or any other support department.
Step Down Allocation Method
The step-down method takes the allocation process one step further. It takes into account that support departments use other support department’s services. This may include the personnel department provides services to employees in the janitorial department. Under this method, allocate costs in a series of steps. First, allocate costs from the most used support department to all remaining departments. Then, choose another support department. Allocate 100% of its costs to the remaining support departments and all the operating departments. And this process is continued until all of the support departments’ overhead have been allocated to the operating departments. While this method is typically a little more complicated than the direct method, it is also more effective in allocating costs.
Reciprocal Method of Allocation
The third method is the reciprocal method. It takes the concept that support departments make use of each other’s resources one step further. This two-step method uses allocation ratios. Thus, the total cost of each support department is calculated based on the formula that total cost for one support department is equal to its costs plus that of the allocated costs from other support departments it accepts services from. The costs include overhead since no support department’s costs are direct costs.
Example of Activity Based Costing
Lets consider a simple example that involves a company with the two following support departments:
This company also has the following two production departments:
- Assembly (with overhead costs of its own of $110,000)
- Finishing (with overhead costs of its own of $60,000)
Let’s further assume that 10 employees work in Janitorial, that Personnel uses 1,000 square feet of building space, that Assembly employs 60 workers in a 4,500 square feet area, and that Finishing has 20 employees who also work in a 4,500 square foot space.
First, involve solving simultaneous equations for the two support departments. For example, P = J = $160,000 + .20P and $250,000 + .10J. This determines the total cost of each support department ($271,429 and $214,286, respectively). Then, allocate support department costs to operating departments based on how much of the support department’s services each operating department used.
In this example, 45% (4,500 sf/10,000 sf) of Janitorial’s total cost would be assigned to each production department; 60% (60 employees/100 employees) of Personnel’s total costs would be assigned to Assembly; and, 20% (20 employees/100 employees) of Personnel’s costs would be assigned to Finishing. Thus, the Assembly Department would have total overhead of $269,286 ($160,000 + $160,857 from Personnel + $96,429 from Janitorial). The Finishing Department’s overhead would total $210,714 ($60,000 + $54,285 from Personnel + $96,429 from Janitorial). These overhead costs would then be allocated to products based on the appropriate cost drivers for each operating department (perhaps machine hours for Assembly and direct labor hours for Finishing).