April 4th, 2006
How To Break Down Activity Based Costing
The indirect overhead component of your business is extremely significant. However, many various food distributing companies don’t understand the workings of their overhead costs and what influences them. In today’s modern organizations indirect overheads are greater than direct costs, much different then the way it was 10-15 years ago. Fortunately Activity Based Costing is a well known method that enables organizations to assign indirect overhead costs to products or services much more sensibly than using conventional costing methods.
Many indirect costs are incurred in service support functions like accounting, quality control, buying materials, order entry, scheduling production, etc. Activity Based Costing allows shows that overheads a business incurs go unaffected by changes in production levels. All organizations perform activities to do business: an accounting firm prepares a tax return, a poultry processor produces a chicken cutlet, a meat distributor supplies an Italian restaurant with sausages, etc. Each different product you offer will require a different number of these activities. For example, small batches of new products could use more resources than large batches of present products or vice versa. It is the not the volume of the products that incurs cost, it is the volume of activities which use the resources that incurs the cost. Thus since all activities that take place consume resources, it is the very consumption of these resources that adds to overhead costs.
Since the whole basis of using ABC is for looking at the activities required to produce the cost of the product or service, the cost of these activities that consume resources can be calculated. The following is a break down of what’s what in ABC:
· The resource is what the activity uses to do the work (i.e. the equipment, the people, etc) and resources cost $$.
· The activity is the work that is performed.
· The cost of the activity depends on the amount of resources used to carry out the activity.
· The cost driver for an activity is the dynamic that determines the amount of the resources that will be used up by this activity:
o For Example: If the activity is delivering goods then the costs include the truck driver’s pay, automobile insurance, depreciation of the truck, money spent on fuel, etc. The number of resources consumed by this activity is directly influenced by the quantity of deliveries completed per year. In this case the cost driver could be the amount of deliveries. A cost driver is designed to allocate the delivery activity cost pool to the cost objects.
· To get a measure of how much of the activity is used by the cost object you look at the activity driver.
o For Example: Product A “Gouda Cheese” is delivered once a month, where as Product B “Italian Sausage” is delivered once a week. Products A and B require a different amount of deliveries, therefore the cost of the delivery activity should not be a set cost, it should be assigned to each product on the basis of the amount of delivery each uses.
· The cost object (which could be anything from a product or service to a process or customer) is whatever it is you wish to cost.
Furthermore, research has shown that 20% of all customers virtually provide all the profits of a company. Another 60% break even and the remaining 20% only reduce the bottom line. Ever wish you could snap your fingers and create a list of the names of those 20% of headache-inducing customers who are generally more trouble than they are worth? Well in order to determine how much an individual customer is costing you, you must first discover the activities that relate to each individual customer and establish the total cost engrossed by those activities. These activities or "cost drivers" should be considered then to measure the level of activity absorbed by each customer. The definitive purpose of implementing ABC is to divide these activities into separate and individual cost drivers. Then, all you have to do is measure each customer's participation in the specific cost.
IT’S THE ACTIVITIES YOU DO THAT DEFINE YOUR BUSINESS
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