Activity Based Costing
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Activity Based Costing Posted: August 24, 2009 at 10:24 am | Tags: Activity Based Costing, Cost Accounting, Managerial Accounting
Activity Based Costing is a costing model that attempts to define the cost relationship between products and customers by assigning rate based costs to activities performed for a customer. Activity based costing can be looked at as sort of an a la carte method of costing where each activity has a rate that is based on a cost factor and each customer is charged based on their consumption of each activity. For example let’s say you were going to lunch with a friend. In order to get to the restaurant you took a cab. You and your friend decided to split the cab evenly. When you got to the restaurant you ordered a salad and a glass of water and your friend ordered the fillet mignon, a side of lobster, a $50 bottle of wine and 2 desserts, one for here and one to go. When the bill came, your friend suggested that you split the bill evenly just like you split the cab evenly. Is this fair? I don’t think so. What would be fair would be to split the bill according to what each of you consumed. Most companies make the same mistake. They assume that since each job consumes the same overhead resources, then each job should split the overhead cost. The reality is that each job does consume the same overhead resources but in different quantities and for different activities. Some jobs require more supervision, design or rework. Let’s walk through an example of the required steps to implement activity based costing in a Software development company. We will create a small software development shop with 7 fulltime salaried employees. This shop builds custom components for accounting systems. We will examine 2 customers to test for profitability. Let’s say our company has the following annual manufacturing overhead costs
Indirect Wages $ 630,000.00
Other Manufacturing Overhead $ 200,000.00
Selling and Administrative $ 200,000.00
Total Overhead Cost $ 1,030,000.00
Table 1. Annual Overhead Costs For comparison we will also calculate the predetermined overhead rate using the traditional single overhead rate approach using total overhead cost divided by annual man hours Total Compensation $ 1,030,000
Man Hours Annual 14560
Predetermined Overhead Rate $ 70.74
In order to implement
activity based costing we will need to define activities, activity cost pools and activity measures. Since we are a development shop we will define typical development tasks See Table 2.
Activity Cost Pool Description Driver Annual Activity
Design Technical Design Man Hours 14560
Build Coding Man Hours 14560
Test Testing of Components Man Hours 14560
Project Management Requirements and Project Management Projects 1000
Customer Support Phone and Online Support Customers 20
Activity Based Costing is a costing model that attempts to define the cost relationship between products and customers by assigning rate based costs to activities performed for a customer. Activity based costing can be looked at as sort of an a la carte method of costing where each activity has a rate that is based on a cost factor and each customer is charged based on their consumption of each activity. For example let’s say you were going to lunch with a friend. In order to get to the restaurant you took a cab. You and your friend decided to split the cab evenly. When you got to the restaurant you ordered a salad and a glass of water and your friend ordered the fillet mignon, a side of lobster, a $50 bottle of wine and 2 desserts, one for here and one to go. When the bill came, your friend suggested that you split the bill evenly just like you split the cab evenly. Is this fair? I don’t think so. What would be fair would be to split the bill according to what each of you consumed. Most companies make the same mistake. They assume that since each job consumes the same overhead resources, then each job should split the overhead cost. The reality is that each job does consume the same overhead resources but in different quantities and for different activities. Some jobs require more supervision, design or rework. Let’s walk through an example of the required steps to implement activity based costing in a Software development company. We will create a small software development shop with 7 fulltime salaried employees. This shop builds custom components for accounting systems. We will examine 2 customers to test for profitability. Let’s say our company has the following annual manufacturing overhead costs
Indirect Wages $ 630,000.00
Other Manufacturing Overhead $ 200,000.00
Selling and Administrative $ 200,000.00
Total Overhead Cost $ 1,030,000.00
Table 1. Annual Overhead Costs For comparison we will also calculate the predetermined overhead rate using the traditional single overhead rate approach using total overhead cost divided by annual man hours Total Compensation $ 1,030,000
Man Hours Annual 14560
Predetermined Overhead Rate $ 70.74
In order to implement
activity based costing we will need to define activities, activity cost pools and activity measures. Since we are a development shop we will define typical development tasks See Table 2.
Activity Cost Pool Description Driver Annual Activity
Design Technical Design Man Hours 14560
Build Coding Man Hours 14560
Test Testing of Components Man Hours 14560
Project Management Requirements and Project Management Projects 1000
Customer Support Phone and Online Support Customers 20
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