Activity Based Costing

What is Activity Based Costing?

Accounting for indirect costs became increasingly difficult as the costs for overhead expenses increased and spreading these costs evenly over the different segements of the business became inaccurate.  Rather than assigning costs to a project, or product, using the traditional man (machine) hour basis, activity based costing takes a more logical approach.  In the activity based costing methodology, a tangible work product is identified which can be measured in terms of units produced, rather than hours spent.  The product is then sub-divided into different definable activities which went into the production.  Each activity is allocated with the appropriate expenses; such as labor, equipment, material costs, and overhead expenses.  Many times, companies will add an overage amount to each activity in order to account for time delays or other items which could delay production and/or increase costs.

Calculating Activity Based Cost

In deriving the cost allocated to each business segment, the following formula can be utilized:

Activity Based Cost = Labor Hours * Hourly Wage + Materials Cost + Equipment Cost + Overhead Expenses

This formula measures the cost associated with performing this activity one time.

Uses of the Activity Based Costing Model

Activity based costing has become very popular in the last 30 years as it allows companies to appropriately distribute & allocate overhead costs to the right cost centers, rather than evenly allocating.  For example, assume that company XYZ was building and selling widgets.  If the company was producing 1 million small widgets and 100,000 large widgets, the activity based cost model would appropriately allocate expenses and overheads to each one based on the specific expenses related to each.  To take it one step further, assume that the large widgets did not need to use the new, expensive equipment in production.  In this case, the small widget would be allocated the cost of the new equipment while the large widgets would be allocated using the cost of use of the older equipment.

In short, ABC allows a company to identify inefficiencies within their organization; this could be at a product level, activity level, or even organizational level.  It helps the company drill down into areas which are spending excessively and alternatively, allows them to dedicate more capital and resources to areas which are very profitable.

Limits to ABC

There are two drawbacks to using this methodology.  Firstly, as you can tell, it is going to be more costly for a firm to produce accounting results which employ this method.  It requires a much higher level of detail and investigation.  Secondly, there are still overhead expenses related to untraceable expenses which fall through the cracks.  Companies will evenly disburse these expenses by cost center and this defeats the purpose of this method.
Tim Ord
Ord Oracle

Tim Ord is a technical analyst and expert in the theories of chart analysis using price, volume, and a host of proprietary indicators as a guide...
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