Activity-Based Costing (ABC): Design and Implementation Principles

Activity-Based Costing (ABC) Fundamentals

Background of ABC Costing

The background of Activity-Based Costing (ABC) stems from the principles established by management accounting experts Robin Cooper and Robert Kaplan. They asserted that the cost of goods must include the cost of all necessary activities employed, not just manufacturing costs.

This means that traditional product costs (raw material, labor, and manufacturing overhead) are supplemented by costs incurred through efforts made for non-manufacturing activities, such as:

• Sales
• Distribution
• Service
• Post-sales support

Defining Activity-Based Costing

ABC is a methodology that assigns costs to products or services based on the consumption of activities. Key characteristics include:

• Manufacturing overhead costs are allocated by activity and subsequently consumed by the products or services.
• It views the company as a set of activities and/or processes rather than relying solely on a traditional departmental hierarchy.

The ABC System Design Process

The process for designing and implementing an effective ABC costing system involves several critical steps:

1. Identify activities.
2. Identify the costs associated with those activities.
3. Determine cost generators or cost drivers.
4. Assign activity costs to cost pools.
5. Assign activity costs from cost pools to the final products or services.
6. Assignment of direct costs to products.

Key Concepts in ABC

Activities

Activities refer to the production processes that occur sequentially and simultaneously. These processes are essential for obtaining the different states of costs that accumulate during production and for determining the value added by each process within the organizational structure.

Cost Drivers (Cost Factors)

To accurately assign a cost to a product, the appropriate Cost Drivers (or Cost Factors) must be identified and utilized. A cost driver is a measurable unit that is clearly identifiable with the activity.

This factor serves as a measurement unit, often used for allocating (prorating) those costs or expenses that cannot be assigned directly to a product or activity. It allows costs to be assigned accurately to a cost center and/or product based on consumption or usage.