Activity-based Costing (ABC) Overview Victor Stefano (151 131 027)

Activity Based Costing (ABC) is a costing system which allocated overhead cost based on its activities that included in the process of making the product. Unlike traditional absorption system which only use one cost driver to allocate its overhead, in ABC different activities have their own cost driver. And the next question is why Activity-based Costing? This system provides a better analysis than traditional absorption system in determining the correct product cost. A better decision making can be obtained by having a more accurate product cost. Although ABC is used in decision making (internal purpose), for financial reports (external purpose) is still using the traditional absorption system. Activity Based Costing differs from traditional cost accounting in three ways (Garrison, et. al, 2012). 1. Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis. 2. Some manufacturing costs may be excluded from product costs. 3. Numerous overhead cost pool are used, each of which is allocated to products and other cost objects using its own unique measure of activity. Activity-based costing defines five levels of activity, unit-level, batch-level, product-level, customer-level, and organization-sustaining. Only the unit level activities do related to the volume of production, while the other remaining levels do not. One reason why ABC provides more accurate product cost information is that traditional costing systems frequently allocate all overhead, including batch-level, product-level, and customer-level overhead, using an allocation base that is appropriate only for unit-level costs. There are five steps in implementing Activity-based Costing. The first step is defining activities, activity cost pools, and activity measures. Defining activities can be time consuming. It is also a trade off between accuracy and complexity. More detailed activity means it will results in more accurate product cost but it also mean the complexity of the ABC is more complex and more time consuming.

The second step is assigning overhead costs to activity cost pools. This step is also called the first-stage allocation, which is defined as the process of assigning functionally organized overhead costs derived from company`s general ledger to the activity cost pools (Garrison, et. al, 2012). First-stage allocations are usually based on the results of interviews with employees who have first-hand knowledge of the activities. The third step is calculating activity rates. This activity rates will be used for assigning overhead costs to products. The activity rates are calculated by dividing the overhead costs allocated to activity cost pools in the first-stage allocation by the total activity occurred. The fourth step, also called the second stage allocation, is using activity rates to apply overhead costs to products. The customer-level and organization-sustaining activities costs are not allocated into products simply because they are occurred not caused by the products. The last step is preparing management reports. The most common reports prepared with ABC data is products profitability reports. With this report management can clearly see the product cost and in turn can see the product margin. By knowing product margins management can make better decision such as focusing on growing sales of products with higher margin rather than products with lower margin.