Activity Based Costing

Introduction

The purpose of this report is to explore Activity Based Costing (ABC) specifically as it applies to the application of overhead costs to jobs in a manufacturing environment. Activity Based Costing is a cost management method which applies overhead costs to jobs in a more accurate manner than that of Traditional Cost Accounting (TCA) by identifying, "Ð'...the cost pools, or activity centers, in an organization and assigning costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or service." (Value Based Management, 2005)

An explanation of the method of assigning costs through Traditional Cost Accounting will be provided, followed by a brief history of Activity Based Costing; an explanation of the ABC process; a comparison of allocation of overhead costs between Traditional Cost Accounting and Activity Based Costing; an analysis of the benefits and drawbacks of Activity Based Costing; and tips concerning how to go about designing and Activity Based Costing system in an organization.

Traditional Cost Accounting (TCA)

Under Traditional Cost Accounting there is a simple method by which some companies continue to implement allocation of overhead for the purpose of arbitrarily assigning indirect costs (overhead) to cost objects (products or services). When using Traditional Cost Accounting, the sum of a company's overhead is allocated among products based on some sort of volume measure. The most commonly used volume measures are labor hours and machine hours. The assumption in TCA is that there is a direct relationship between overhead and the volume of output based on the volume measure (Value Based Management, 2005).

Since an exact number for overhead cannot be determined until the end of the period (whether that period is a month, quarter, or year) a predetermined factory overhead rate must be used to apply overhead to products. This is done by estimating the overhead for the period, and then dividing it by the estimate of the volume measure for that particular period (Delphis Financial Management and Consulting, 2005). For example, if a company expects overhead expenditures of $500,000 in one year with 125,000 direct labor hours, the predetermined factory overhead rate which will be applied to any particular job would be $4 per direct labor hour. Once the period is completed, actual overhead and direct labor hours are computed for the year, and the difference between actual overhead and overhead applied to any particular job is called over (under) applied overhead.

A simple example of assignment of overhead costs under the Traditional Cost Accounting method is as follows:

Widgetland manufactures widgets with overhead costs applied at a predetermined rate of $2 per direct labor hour. Widgetland produced 10,000 widgets in April 2005 with a total of 10,000 direct labor hours. Overhead assigned to the product of widgets totals $20,000.

Under Traditional Cost Accounting, an organization may go a step further by breaking down the application of overhead by department. In this situation, cost drivers specific to any particular department are used to determine the application of overhead (i.e. direct labor for the assembly department, machine hours for the machining department, etc.). Although this method increases the accuracy of applying overhead costs, the underlying assumption (and possible incorrectness) of the direct relationship between overhead and the volume of output based on the volume measure still does not take into account the possibility of any other contributing factors to overhead costs.

The drawback of assigning costs based on a predetermined overhead rate (as stated above) is the assumption that the selected cost driver (in this case, direct labor) is what drives a large percentage of the costs in an organization. In most organizations, there is no one single cost driver, rather a multitude of cost drivers. This is where Activity Based Costing becomes more appropriate than traditional costing methods (Delphis Financial Management and Consulting, 2005)

History of Activity Based Costing

Up until the early 1980s, the traditional costing method detailed above was implemented in a majority of corporations. Most companies utilized a cost model that was developed in the early 1900s,

"Ð'...when labor was the most important factor in production and product and service variety was very limited. At the time they were created, the models were reasonable representations of the internal economics at most businesses. As businesses became more complex and product and service customization grew, however, companies failed to change their models to match the changes in reality." (Hicks, 2005).

Soon, however, the drawbacks of traditional costing methods became clear to upper level management as researchers began to point out the outdated procedures and the inadequacies of those cost models. A professor at Harvard University, Robert Kaplan, began to develop an alternate costing system which was eventually given the name Activity Based Costing, and gave rise to Activity Based Management (Hicks, 2005).

Activity Based Costing (ABC)

Dependent upon which resource is utilized for research of this topic, there is a range of three to eight steps through which one may implement Activity Based Costing in an organization. Each of these independent resources carry the same requirements for implementation, however, they are organized differently dependent upon the author. For the purpose of this report, a five step process will be illustrated based on a University of Pittsburg presentation given by Narcyz Roztocki. Data from this presentation was also utilized in order to provide an illustration of Activity Based Costing through a figurative manufacturing organization named Company XYZ, which produces two products: Product A and Product B.

The five steps towards implementation of Activity Based Costing are as follows:

1. Identify activities

2. Determine cost for each activity

3. Determine cost drivers

4. Collect activity data

5. Calculate product cost (Roztocki, 1998)

Identify Activities

This first step entails an evaluation of corporate resources. This is where a company determines the resources, funds, and processes required to manufacture any particular product.