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Activity-Based Costing Explained

Activity-Based Costing enables company management to effectively get the full benefits of project management methodologies. “Failure to apply Activity-Based Costing (ABC) may well be causing you to outsource work which in reality is a ‘core competency’ (Those activities you do better than others and make money at) and keep in-house work which you are actually losing money on. Using traditional accounting approaches results in high volume, low complexity products or services being [over-priced] by as much as (200%) while low volume/high complexity products or services are being [under-priced] by up to 1,000%.

Activity-Based Costing (ABC) is the only accounting approach which will fairly give us a selling price that reflects the fair and true costs associated with a project or service” (Giammalvo 2007: 1). Meanwhile, a cost driver is “a factor that has a direct cause-effect relationship to a cost; [it is] an activity creating a cost. [They are generally] classified either as volume-related – like machine hours – or non-volume related, which generally reflect the incurrence of specific transactions (such as setups, work orders, or distance traveled” (Raiborn, Kinney and Prather-Kinsey 2006: G-3)

The term “cost pool” pertains to “a collection of monetary amounts incurred either for the same purpose, at

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the same organizational level, or as a result of the occurrence of the same cost driver” (Raiborn, Kinney & Prather-Kinsey 2006: G-3). Examples of cost pools are total factory overhead, variable factory overhead, and fixed factory overhead. Cost Pools and Cost Drivers Illustrated (Source: Ellen Sweatt) Thus, cost pools can be established based on specific parts of the entire manufacturing process, then under each cost pool will be the cost drivers.

These two help management get to the bottom of costs making up the bulk amounts reported on a per-transaction or a per-product basis. 3. Activity-Based Management (ABM) is defined as “a discipline that focuses on the activities incurred during the production/performance process as the way to improve the value received by a customer and the resulting profit achieved by providing this value” (Raiborn, Kinney & Prather-Kinsey 2006: G-1). Thus, the determination of product costs is not just the concern of the accounting department of a company.

Management has to be keenly updated on cost-related issues. In its bid to effectively oversee the activities of the company, management should be able to identify and address the concerns, and to continually improve the company’s market share by ensuring healthy profits for the company and equitable returns for the company’s investors. Activity-Based Management, hence, is an aspect of overall management that should be implemented in the company for the acknowledged benefits that Activity-Based Costing and its underlying procedures bring in.

Activity-Based Budgeting, meanwhile, is “the process of formalizing plans [pertaining to activity-based production processes] and committing them to written, financial terms” (Raiborn, Kinney & Prather-Kinsey 2006: G-2). It is the approach of producing budget-related reports that use formats in consistency with Activity-Based Costing. Therefore, these budgets would classify cost items as cost drivers and would group costs also by cost pools, all in accordance with the underlying principles of Activity-Based Costing.

Activity-Based Budgeting does not base the current year’s budget on the past year’s budget plus the effects of inflation and cost of money. Instead, it goes all the way to allocate resources based on the cost pools per activity and the cost drivers within each cost pool. Given these details that will have to be included in the Activity-Based Budgets, such budgets, therefore, provide more reliable details about the overhead items included in the various parts of the operations. (BusinessDictionary. com 2008)

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