Activity based costing is a complex cost accounting system and it should be implemented only when its benefits are more than the cost incurred to implement this. In order to implement the ABC system, follow five steps are important:
1. Identification of cost activities
The first step in ABC is to identify the activities which are done to produce the goods or products. In order to better understand the activities, you may take support from tools such as interviews and questionnaires. The problem is that you may end up identifying hundreds of activities which is off course not a good solution.Instead, here you have to use your best judgement to narrow down the activities. As a guide, only choose activities which have the biggest impact on the overheads. Example of these activities are:
Purchasing the raw materials, preparing machines, running the machines, assembling components and inspecting the final finished products.
2. Assign the overheads to activities
In this step, we assign various overheads to the activities identified in step 1. For example, there will be staff salaries for performing various activities identified in step 1. There will be other costs as well which need to be linked to above activities. Once various costs are assigned to these activities, this is called cost pool.
3. Identify the cost drivers
Now, it is the time to define the cost drivers for each activity. This step also involves interview process from various staff in different departments. Most common cost drivers are machine setups, direct labour hours, machine hours and purchase requisitions etc.
4. Predetermined Overhead Rate
Management accountant needs to calculate Predetermined Overhead Rate. This can be obtained by dividing the estimated manufacturing overhead identified in step 2 by the cost driver identified in step 3.
5. Allocate overheads to each product
Finally, management account apply the predetermined overhead rate to each product activity level to allocate the overheads to each product.