The Activity-Based Costing Process

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  • 0:03 Activity-Based Costing
  • 0:38 Using Activity Cost Pools
  • 1:13 Finding Activity Rates
  • 2:04 Assigning Overhead to…
  • 2:44 Reporting it All
  • 3:05 Lesson Summary
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Lesson Transcript
Instructor: Kevin Newton

Kevin has edited encyclopedias, taught history, and has an MA in Islamic law/finance. He has since founded his own financial advice firm, Newton Analytical.

With computers, it's now possible to provide costs for virtually every activity that touches a product. In this lesson, we'll learn about the activity-based costing process and how it works.

Activity-Based Costing

Technology has had a massive impact on plenty of areas in business. Accounting is no different. With the development of computer-based spreadsheets that can quickly calculate otherwise cumbersome numbers, managers are able to track costs with better accuracy than ever before. This has led to a rise in the use of activity-based costing, a method of tracking costs as they are applied to each unit, batch, product line, or facility of production. In the past, managers would lump all overhead expenses into one broad category and allocate them by one driver, usually labor hours or dollars. Now, they are able to track them more accurately than ever before by using multiple cost drivers.

Using Activity Cost Pools

First things first, we have to determine where a cost goes. That means putting it in the proper activity cost pool. An activity cost pool tells us where the cost is coming from. For example, an accounting expense would have an accounting department as the activity cost pool. From here, we can also find out the activity cost driver, which is the actual expense categorized. The accounting department may increase overhead expenses by preparing tax returns, but it may also increase expenses by making sure that employees are paid. Either one of these can be a cost driver within the cost pool of the accounting department.

Finding Activity Rates

Next, we have to find the activity rates. An activity rate is the cost of a particular overhead item divided by the relevant units of the cost driver. Remember earlier we talked about how costs could be tracked for multiple levels of production, or by the unit, batch, product line, or facility? This is where it comes into use. The activity rate is found by dividing cost by the number of units of the cost driver. So, let's say your factory made 100,000 widgets last month and accounting spent $10,000 on paperwork for salaries. This would mean that the cost driver, number of widgets for salaries' would have an activity rate of $10,000 / 100,000 or 10 cents per widget. Meanwhile, if there was a special order that required a batch of 100 widgets to be made, but only that batch had an additional cost of $500 since the accounting dept had to work on a Saturday, then each widget in that batch would have an extra activity rate of $500 / 100 = $5.

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