One of the more challenging aspects of creating an activity-based budget is how to include costs for activities not directly related to products and services.
Traditional costing methods and approaches to budgeting arbitrarily allocate costs, often adjusting them based on prior years’ values.
Activity-based costing takes allocation of expenses a bit further and works to allocate indirect costs in a more structured way.
Typically, activity-based costing is used in manufacturing businesses where indirect costs can be allocated to a unit of production. However, the costing method has other practical applications in a wide variety of industries.
In this FAQ, we will discuss what activity-based costing is, why it is important, and how to do it.
What Is Activity-Based Costing?
Activity-based costing is an accounting methodology that attempts to allocate overhead and indirect costs to specific business activities.
Once a cost driver is associated with an activity, the expenses can then be assigned to the cost objects that use those activities—for example, a manufactured good, service, or other product that utilizes the cost objects.
Activity-based costing is an approach that yields more benefit in environments where processes are intertwined and complex. This means it is not the best approach in more streamlined and simple environments.
Activity-based costing is an approach that is used to track the cost of business activities. In this way, it is a helpful tool for benchmarking a business’s costs against industry standards.
This should not be confused with activity-based budgeting, which is budget driven by the costs of business activities. While the two are complimentary, they are different entirely.
An activity-based budget is a form of budgeting while activity-based costing is an accounting methodology to allocate expenses to activities. This makes the latter a good tool to use when building an activity-based budget.
Why Is Activity-Based Costing Important?
There are a host of benefits underlying activity-based costing, but its distinct advantage over other forms of costing is that it reveals exactly how much overhead is used in each business activity.
This means once you have an activity-based costing system in place it can convey pertinent information on the costs of an activity, which can then be analyzed further.
Activity-based costing can also help to answer questions surrounding profitability and help with making production decisions as well.
For example, activity-based costing helps to identify excess overhead cost as it relates to specific customers. This can help business leaders determine if existing relationships are worth expanding or reducing.
Many businesses rely on multiple distribution channels to get products to customers. These often include retail space, internet sales, distribution networks, and in some cases mail order.
Activity-based costing is used to determine the costs of maintaining these various distribution channels and can be used to identify which channels are the most profitable.
Finally, because activity-based costing allocates costs precisely, it is a helpful tool in assessing margins on products and services.
Understanding which units, services, or subsidiaries have the largest margins can help business leaders assess where resources are best allocated and how the business should position itself in the market.
These are only a few key benefits of activity-based costing.
How to Perform Activity-Based Costing
There are five primary steps to performing activity costing that results in two primary outputs.
The steps are progressive and should be followed from start to finish, with the outputs being reporting and action.
Step 1: Identify All Costs
The first step might be obvious, but it’s critical. Identifying every cost is the most important part of the process and should be performed with diligence.
One of the major reasons activity-based costing results in reduced costs is that it identifies redundant or excessive costs that can be eliminated. This makes activity-based costing a complimentary procedure to activity-based budgeting.
Step 2: Load Secondary Cost Pools
A secondary cost pool is a group of indirect costs that are not related to a product or service but are still incurred during the normal course of business.
These might include administrative salaries, IT support, phone support, or any other ancillary activity that has expenses.
The secondary cost pools will be used later in the process to allocate to cost pools that are more appropriately related to products and services.
Step 3: Load Primary Cost Pools
Primary cost pools are a set of cost pools that are closely or directly related to a product or service.
Step 4: Identify Drivers of Activity
Gather information about the drivers behind each business activity. Use this information to identify which primary and secondary cost pools they should be allocated to.
Step 5: Allocate Cost to Objects
First, allocate each primary cost pool to cost objects by using the activity driver as a guide. Keep in mind, each pool has its own activity drivers.
Allocate cost to objects by dividing the total cost in each cost pool by the total amount of activity in the activity driver behind the cost pools.
Once the cost per unit activity is calculated, allocate the total cost per unit to the cost objects based on their use of the activity drivers.
Step 6: Reporting and Action
Management reports should utilize the information provided through activity-based costing to provide a more comprehensive view of margins and revenues on which they can make business decisions.
Using DataRails to Help With Your Activity-Based Costing
Every FP&A analyst knows how challenging performing activity-based costing can be. Regardless of the budgeting approach your organization adopts, it requires big data to ensure accuracy, timely execution, and of course, monitoring.
DataRails is an enhanced FP&A solution that can help your team create and monitor budgets faster and more accurately than ever before.
By replacing spreadsheets with real-time data and integrating fragmented workbooks and data sources into one centralized location, you can work in the comfort of excel with the support of a much more sophisticated data management system behind you.
This takes budgeting from time-consuming to rewarding.