What are the steps involved in implementation of Activity Based Costing?

Answer 1

The implementation of Activity Based Costing is not simple, easy & direct as is the case with traditional costing. It requires proper steps or techniques to be followed, which are listed as follows:

Step 1: Identification and classification of the activities related to the company's products. Activities in all areas of the value chain (product design, production, marketing, distribution, etc.) must be included. Activity dictionary is prepared, which includes all the activities that a company performs to produce its product or service. The activity dictionary can be prepared in different ways, including interviewing the employees who perform the activities. After the identification of activities, they are classified as unit level, batch level, product level, customer level or facility level.

Step 2: Estimation of the cost of activities identified in step 1. Estimate the costs of specific activities that generate costs. These costs are for both human resources, such as employee labor for production and machine maintenance, and physical resources, such as the cost of machinery and building occupancy. Information must include employee data from personnel interviews and financial data from the accounting department. Then the total cost of each activity is calculated.

Step 3: Calculation of cost-driver rate for each activity. The activity cost data from step 2 is used to calculate a cost-driver rate that the company can use for assigning activity costs to goods and services. This rate should use a base that has some causal link to the cost. That base is called activity drivers. For example, the costs of running a production machine are likely to be caused by the number of hours it runs. Thus, choosing a rate for this activity based on machine hours is appropriate.

Step 4: Assign activity costs to products. The cost-driver rates prepared in step 3 are used to assign activity costs to goods and services. For example, if a particular product uses 1.5 machine hours in production and the rate from step 3 is $50 per hour, the product is assigned $75 based on its machine usage.

After the completion of the four steps mentioned above, a company can compute the cost of overheads provided to existing goods and services, which can be used to understand the profitability of each product in a better way. The activity-based costing data could also be used to estimate the cost of future products.