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How Does Activity Based Costing Work
Professor Claudine Carew
December 4, 2012
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An organization wanting to capture all costs would be inclined to adopt activity-based costing. Why would an organization want to adopt this cost allocation method? Steps involved in developing a system that works will provide an understanding of why organizations are choosing to implement activity-based costing.
Per our textbook, “Activity-based costing (ABC) is a two-stage product costing method that assigns costs first to activities and then to the products based on each product’s use of activities.” It is a simple concept that “products consume activities and activities consume resources.” With this method of approach, costs are not assigned to “departments or buildings”. This system relates overhead to activity use, rather than volume of output. A traditional costing system has only one overhead cost pool in a production department. This cost pool is normally machine hours and direct labor hours.
When a company has done enough research and have decided upon adopting Activity-Based Costing, they are ready to develop their Activity-Based costs with the development of four steps. These four steps include: “1) Identify the activities – such as processing orders, that consume resources and assign costs to them. ‘An activity is any discrete task that an organization undertakes to make or delivery a product or service.’ 2) Identify the cost driver(s) associated with each activity. A cost driver causes, or “drives” an activity’s costs. For the order-processing activity, the cost driver could be the number of orders.
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3) Compute a cost rate per cost driver unit or transaction. The cost driver rate could be the cost per order, for example. 4) Assign costs to products by
multiplying the cost driver...