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Implementing Activity Based Costing

See Also:
Segmenting Customers for Profit
Activity Based Management
Standard Costing
Process Costing
Activity Based Cost Allocation

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.


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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.

ABC Costing

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:

  • Janitorial (with a budget of $160,000)
  • Personnel (with a budget of $250,000)

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).

Implementing Activity Based Costing

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Job Costing

See Also:
Implementing Activity Based Costing
Standard Costing System
Process Costing
Activity-based Costing (ABC) vs Traditional Costing
Absorption vs Variable Costing

Job Costing Definition

Job costing is defined as a method of recording the costs of a manufacturing job, rather than process. With job costing systems, a project manager or accountant can keep track of the cost of each job, maintaining data which is often more relevant to the operations of the business.

Job Costing Meaning

Job costing, generally, means a specific accounting methodology used to track the expense of creating a unique product. Due to the fact that certain projects, such as construction, require different operations, accountants use this methodology to trace the expenses of each job in order to use this information for analysis and tax needs. Job costing forms have spaces to include direct labor, direct materials, and overhead.

Costs stay in the work-in-process account throughout the job. When the job is finally completed, they are transferred to the finished goods account. By using this method, accountants can make sense of complicated jobs which are moving towards the process of completion.

Indirect costs, like overhead, are applied as a fraction of direct costs. This is usually done in one of two ways: an association with labor hours or using activity based costing. This way, either through use of labor or certain tools, overhead will not be left out of the equation and a company can make sure to cover all essential costs using job costing.

Industries which produce products as jobs use this method. This includes job costing for construction, but goes much farther than just this. Shipping, auditing, maintenance and repair, installation, and any industry which creates products unique to each need. In this situation, job costing is often the most efficient method.

Job Costing Example

For example, Roy was once the curator of a large museum in the United States. Connecting with the science community on many levels, he has enjoyed his career. After some time, Roy decided he would make a career change. He has since started a company which provides maintenance work on historical works which reside in museums.

Roy has all the connections he needs for this business: other curators, archaeologists, and the entire community in his rolodex. After a little effort, he was able to connect with the people who perform this work. Roy will take the role of salesperson, but he needed to hire a team to perform operations. Roy is quite successful. His one concern, an area of ignorance for him, is how the bookkeeping will take place. So he hires an accountant, sets a meeting, and begins to learn about how his business will overcome this need.

The Most Efficient Accounting Methodology

The accountant shares that job costing will be, probably, the most efficient accounting methodology. Roy can keep track of the costs for each of his contracts by implementing this type of accounting. He will be able to find which items take more or less time to maintain. Additionally, he can make sure to create company profits by adding a margin on top of his costs. By using a job costing software, bookkeepers can run the system quite smoothly.

Roy can rest at ease with this accounting method. Knowing he can rely on his accountant, Roy begins to contact prospect customers and former peers. He has confidence that his business will be a success. He looks forward to gaining his first customer.

Job costing is just another way to know your economics or financials. Click here to download the Know Your Economics Worksheet to shape your economics to result in profit.

Job Costing

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Job Costing

 

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Cost Driver

See Also:
Cost Center
Value Drivers: Building Reliable Systems to Sustain Growth
Direct Labor Variance Formulas
Direct Material Variance Formulas
Step Method Allocation

Cost Driver Definition

In accounting, the cost driver definition is a factor that incurs cost. Use cost drivers to allocate variable and indirect costs to production activities or output. Include both indirect costs and direct costs to compute the full cost of production. Because indirect costs, such as variable overhead, are not directly traceable to production activities, allocate them according to a cost driver rate to apply these costs to production activities. Based on the activity of the cost driver, the cost driver rate is the rate indirect costs applied to production activities.


Download the free Know Your Economics guide to easily manage the factors incurring costs in your company.

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Choosing Cost Drivers

An indirect or variable cost may have several possible cost drivers. Traditional costing methods allocate indirect costs to production activities based on volume of output. Conversely, activity-based costing allocates indirect costs to particular production activities related to that cost.

When deciding which driver to use in terms of allocating indirect cost, consider the cause-and-effect relation between the cost and the driver. In addition, consider whether or not the cost driver activity is easily measurable. It is also necessary to consider the cost behavior of the relevant cost. The relevant cost refers to the cost’s response to the activity of the driver. In addition, approximate the relationship between costs and cost drivers using regression analysis.

Use these drivers at differing hierarchical levels. For example, an indirect or variable cost may be relevant at the unit level, the batch level, the product level, the customer level, or the facility level. Once you determine the appropriate hierarchical level, choose a cost driver activity at that level in order to allocate the indirect or variable cost.

Cost Driver Rates

A cost driver rate is the amount of indirect or variable cost assigned to each unit of cost driver activity. For example, you may apply indirect overhead to direct labor hours as $50 dollars per hour. In this case, for each hour of direct labor required for production, the company would then allocate $50 of indirect overhead costs to the production activities or output.

Cost Driver Examples

For illustrative purposes, below are some cost driver examples of indirect or variable costs as well as relevant cost driver bases for these costs.

CostCost Driver 
Maintenance expenseMachine hours
Fuel costsMiles traveled
Electricity expenseHours of factory operation
Material handling expenseTons of material handled

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cost driver, Cost Driver Definition, Choosing Cost Drivers, Cost Driver Examples

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cost driver, Cost Driver Definition, Choosing Cost Drivers, Cost Driver Examples

Source:

Hilton, Ronald W., Michael W. Maher, Frank H. Selto. “Cost Management Strategies for Business Decision”, Mcgraw-Hill Irwin, New York, NY, 2008.

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Cost Accounting

See Also:
Accrual Based Accounting
The Future of the Accounting Workforce
Absorption vs Variable Costing
Implementing Activity Based Costing
Process Costing
Management Accounting

Cost Accounting Definition

The common cost accounting definition is accounting which seeks to create then compare a budget to the actual cost of doing business. In cost accounting, budgeting aids in decision making with regards to minimizing costs and increasing profit.

Cost Accounting Description

Cost accounting is a form of managerial accounting and is used for the benefit of internal managers. Due to this fact reports need not follow GAAPFASB, or other accounting standards and procedures. Cost accounting, ultimately, is focused on reducing costs and increasing profit. Costs, for the purpose of creating uniform reports, are measured in one form of currency.

The purpose of cost accounting is strategic decision making. With effective cost accounting measurements managers can make key decisions on price, product offerings, technologies, and controls for short term and long term planning.

The foundation of this purpose is measurement and analysis. With incomplete records come partial decisions, some managers must take great effort to ensure proper data procedures. After completing this daunting task, managers must then derive accurate decisions based on quantitative and qualitative analysis of internal records and external variables.


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Cost Accounting Techniques

There are many methods for a cost accounting standards guide. Pivotal cost accounting techniques include the following:

Cost accounting is an extensive field. The cost accounting basics, however, are simply described as the following:

These explanations may fall under a different name, however the concept and purpose behind most cost accounting terms will remain similar.

Cost Accounting Example

For example, Stan is the CFO for a financial services company called Financeco. Stan believes the company is spending too much in total costs for servicing one customer. As a result, he wants to reduce the total cost of servicing one customer to increase the profit received from each one. A trained CFO is an authority for any situations that require cost accounting solutions.

So, Stan begins by looking at the company cost of goods sold (COGS). He sees satisfactory results but wonders if he can do better. While looking at this he realizes that a large portion of these expenses come from processing customer paperwork and monthly reports. He begins to study, measure results, and form a plan of action.

Stan finds that the company makes $2400 per year off of the average customer. In comparison, he also finds that the company spends a total of $400 per year in paperwork processing. He studies the experience of the customer and realizes a main flaw.

Financeco uses paper-based record keeping instead of computerized databases. On the front end, by encouraging the customer to apply to Financeco online the company can slash the first half of total paperwork processing by 30% ($200 X 30% = $60 cost reduction per customer). To encourage this he suggests waiving the $25 application fee for clients who apply online.

Stan’s Plan

On the back end, Stan believes he can convince clients to “go paperless” with monthly reports. By providing clients with an online system to view reports he can completely remove the other half of paperwork processing. To do this, Stan suggests a new portal to their website. With a one time capital expenditure of $20,000 he can remove $200 of yearly costs per customer. Stan suggests that the company market this change as “Financeco going Green”. For customers not motivated by the environmental benefits of the new system, give a temporary price reduction. A per client, year-end rebate can be budgeted to each sales agent on an as needed basis.

Stan estimates that this change will cost the company approximately $40,000 ($20,000 for web design and an additional $20,000 for training hr for the transition.). He creates his report and prepares to meet with the company’s Board of Directors.

Stan’s plan is a welcomed change to the Financeco Board of Directors. They embrace the plan and begin making the necessary changes to company processes.

Cost accounting systems, cost accounting software, and other tools will ease the task of the manager. Without a foundation of measurement and analysis, however, Stan would have never experienced success in his project.

If you want to increase the value of your organization, then click here to download the Know Your Economics Worksheet.

cost accounting, cost accounting techniques, cost accounting definition

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Activity-based Costing (ABC) vs Traditional Costing

See Also:
Activity Based Costing
Standard Costing System
Cost Driver
Value Chain
Implementing Activity Based Costing
Absorption vs Variable Costing
Activity Based Management
Process Costing
Overhead
Job Costing

Activity Based Costing Costing vs Traditional Costing

In the field of accounting, activity-based costing and traditional costing are two different methods for allocating indirect (overhead) costs to products.

Both methods estimate overhead costs related to production and then assign these costs to products based on a cost-driver rate. The differences are in the accuracy and complexity of the two methods. Traditional costing is more simplistic and less accurate than ABC, and typically assigns overhead costs to products based on an arbitrary average rate. ABC is more complex and more accurate than traditional costing. This method first assigns indirect costs to activities and then assigns the costs to products based on the products’ usage of the activities.

Traditional Costing Method

Traditional costing systems apply indirect costs to products based on a predetermined overhead rate. Unlike ABC, traditional costing systems treat overhead costs as a single pool of indirect costs. Traditional costing is optimal when indirect costs are low compared to direct costs. There are several steps in the traditional costing process, including the following:

1. Identify indirect costs.

2. Estimate indirect costs for the appropriate period (month, quarter, year).

3. Choose a cost-driver with a causal link to the cost (labor hours, machine hours).

4. Estimate an amount for the cost-driver for the appropriate period (labor hours per quarter, etc.).

5. Compute the predetermined overhead rate (see below).

6. Apply overhead to products using the predetermined overhead rate.

Predetermined Overhead Rate Calculation

Use the following formula to calculate predetermined overhead rate:

Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost-Driver Amount

For example:

$30/labor hr = $360,000 indirect costs / 12,000 hours of direct labor

Activity-Based Costing Benefits

Activity based costing systems are more accurate than traditional costing systems. This is because they provide a more precise breakdown of indirect costs. However, ABC systems are more complex and more costly to implement. The leap from traditional costing to activity based costing is difficult.

Traditional Costing Advantages and Disadvantages

Traditional costing systems are simpler and easier to implement than ABC systems. However, traditional costing systems are not as accurate as ABC systems. Traditional costing systems can also result in significant under-costing and over-costing.

If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

activity based costing vs traditional costing

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Activity Based Costing

See Also:
Activity-based Costing (ABC) vs Traditional Costing

Activity Based Costing

Activity based costing is a system that attempts to accurately trace indirect costs to products by allocating indirect costs to activities and then to products based on their usage of the activities. ABC is optimal when accuracy is very important and when indirect costs comprise a large proportion of total costs compared to direct costs.

ABC is commonly used in the manufacturing sector. A reason why it is so useful for the manufacturing sector is fairly obvious, by allocating indirect costs to products based on usage, a company can more accurately see where the resources and energy is going in their company. By figuring out where the money and energy is going, efforts can be focused upon those products that are eating up the most time and energy. This will eventually lead to a drop in cost, in theory, as efforts will be made to reduce the costs on the bulk of the products. Activity based costing is all about efficiency. Efficiency is paramount to success and growth within a company and that is why activity based costing is an effective way to allocate indirect costs within a company to products.

Activity Based Costing Steps

Th four following steps include the activity based costing process:

1. Identify and classify all of the activities in the value chain related to the production of the product.

2. Estimate a total cost for each of the activities identified.

3. Compute a cost-driver rate for each activity based on a cost allocation base that has a causal link to the cost of the activity.

4. Apply activity costs to products using the appropriate cost-driver rate.

Activity-Based Costing Example

For example, a company identifies and classifies machine maintenance as an indirect cost activity. Based on historical data, the company estimates machine maintenance costs to be $1,000 per month. The company determines that batches of product produced on the machine are an appropriate cost-driver allocation base for machine maintenance costs. The machine typically produces 500 batches per month. Thus, the cost-driver rate would be $1,000/500 batches, or $2/batch. So, for each batch of product produced, the company would apply $2 of indirect cost for machine maintenance.

If you want to add more value to your organization, then click here to download the Know Your Economics Worksheet.

activity based costing

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Access your Strategic Pricing Model Execution Plan in SCFO Lab. The step-by-step plan to set your prices to maximize profits.

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activity based costing

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Implementing Activity Based Costing

All of us have used cost allocation as part of our Financial Services offerings since it is required by GAAP. Cost allocation is the process of assigning common costs to ending inventory and cost of goods sold (COGS). Our goal has been to either reduce taxes or increase reported earnings, but this all depends 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)?

Implementing Activity Based Costing

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 can more accurately assess the true cost of a product or service. Then they can determine if carrying certain products and/or services contributes to overall profitability given the demand for and price these products/services sell for. This is especially important as it pertains to both operational decisions and capital/long-term decisions.

Some of the operational decisions include the following:

  • 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
  • In making special order and transfer pricing decisions

Some of the capital/long-term decisions include the following:

Cost Allocation

You can also use cost allocation to reduce wasteful spending and/or promote more efficient use of resources (especially PP&E). Accomplish this 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. You can also use it to manage product and process design. As one breaks down and/or determines allocations, the use of resources becomes transparent from a process standpoint. This allows managers to improve operations as needed….

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Implementing Activity Based Costing, Cost Allocation

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