Activity Based Costing

Posted: August 24, 2009 at 10:24 am | Tags: Activity Based Costing, Cost Accounting, Managerial
Accounting

Activity Based Costing is a costing model that attempts to define the cost relationship between products and
customers by assigning rate based costs to activities performed for a customer. Activity based costing can be
looked at as sort of an a la carte method of costing where each activity has a rate that is based on a cost
factor and each customer is charged based on their consumption of each activity. For example let’s say you
were going to lunch with a friend. In order to get to the restaurant you took a cab. You and your friend
decided to split the cab evenly. When you got to the restaurant you ordered a salad and a glass of water and
your friend ordered the fillet mignon, a side of lobster, a $50 bottle of wine and 2 desserts, one for here and
one to go. When the bill came, your friend suggested that you split the bill evenly just like you split the cab
evenly. Is this fair? I don’t think so. What would be fair would be to split the bill according to what each of
you consumed. Most companies make the same mistake. They assume that since each job consumes the
same overhead resources, then each job should split the overhead cost. The reality is that each job does
consume the same overhead resources but in different quantities and for different activities. Some jobs
require more supervision, design or rework.

Let’s walk through an example of the required steps to implement activity based costing in a Software
development company. We will create a small software development shop with 7 fulltime salaried employees.
This shop builds custom components for accounting systems. We will examine 2 customers to test for
profitability.

Let’s say our company has the following annual manufacturing overhead costs
 Indirect Wages
$ 630,000.00

Other Manufacturing Overhead

$ 200,000.00

Selling and Administrative

$ 200,000.00

Total Overhead Cost

$ 1,030,000.00

Table 1. Annual Overhead Costs

For comparison we will also calculate the predetermined overhead rate using the traditional single overhead
rate approach using total overhead cost divided by annual man hours

Total Compensation
$ 1,030,000

Man Hours Annual

14560

Predetermined Overhead Rate

$ 70.74

In order to implement
activity based costing we will need to define activities, activity cost pools and activity measures. Since we are
a development shop we will define typical development tasks See Table 2.
 Activity Cost Pool
Description
Driver
Annual Activity

Design
Technical Design
Man Hours

14560

Build
Coding
Man Hours

14560

Test
Testing of Components
Man Hours

14560

Project Management
Requirements and Project
Management
Projects

1000

Customer Support
Phone and Online Support
Customers

20