The activity based costing (ABC) approach differs from traditional costing methods in the way that it uses activities that receive their costs from consuming resources. ABC is a way of costing variety and complexity in production, not just linking costs between resources and physical volumes produced. Using ABC provides a more accurate calculation of the real cost of the product, identifies break-even points, ranks parts from money makers to money losers, etc.
The basic approach is to connect activities of the system to resources and cost centers. The activities are attributed to inventory parts. It is possible to attribute costs to certain products that are more complex and varied than the standard product produced, by adding at least one activity directly to that product.
Instead of arbitrarily raising the machine cost or creating special, virtual work centers for the complex products, you can assign activities with drivers (e.g., number of setups and number of setup hours) to the specific products in question. Products that tend to need more setup time, engineering, or other preparations would thus carry more of the overhead costs than the standard product.
The following section describes the work flow of setting up an ABC system. The work flow is a suggested way of working with activity based costing; naturally, you can, if you want to, devise your own way of working with it.
It is the activities within the company that consume resources. Even though the number of activities varies from company to company, try to find the 10-15 most important and frequently used activities within your company.
The cost centers are defined, together with a budgeted cost, per time period. The time period can be as short as a daily period, but the suggested time period is for a quarter, semi-annual, or annual cost definition.
An activity must be linked to a cost center in order to be able to pass costs down to the final carrier of the cost, i.e., the parts. For this purpose, you define a factor by which the activity consumes costs from the cost center. An activity can consume costs from several different cost centers.
This is where the activity cost driver rate is calculated. The activity cost driver rate is the rate of cost for each activity. The rate obtained from the cost center divided by the estimated use of the activity cost driver comprises the cost that the activity carries to any associated part.
When an activity is created, a bucket with the same identity is created. The activity and bucket bear a one-to-one relationship. They are treated the same way, regardless of whether the bucket content comes from activities or from elements.