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.
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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Now it's time to actually assign overhead to each unit of production. Gather up all the relevant activity costs for each item, and charge them as the overhead cost for each unit.
Here's where you're glad you've got modern technology. Let's just use the figures from above to keep things simple, but keep in mind that a single unit can have dozens of activity rates. Every unit in our factory would get a 10 cent overhead cost as a result of the paperwork for salaries. However, those units in the special order would get an extra $5 markup. Therefore, with just those two costs factored in, most units are only at ten cents of overhead, while that batch of 100 units is at $5.10.
Reporting It All
Again, when it comes time to report all of this information on the manufacturing overhead budget, you'll be happy that you have spreadsheets! Each unit, batch, product line, and facility gets its own subsection where each cost that's acted upon is listed. In other words, it's a lot of paperwork. However, the flip side of this, is that everything is accounted for down to the penny.
In this lesson, we learned how to use activity-based costing to figure out exactly how much our overhead costs really were. Activity-based costing assigns a number, known as the activity rate, for every expense that is incurred. These are assigned on the basis of per-unit, per-batch, per-product, or facility-wide production. From there, each entry gets its own spot in determining the exact overhead cost of each unit manufactured.
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