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How to Implement a Simple Activity-Based Costing System

Activity-based costing (ABC) systems don't have to be that complicated, particularly if you just want better allocation of your overhead costs rather than a system to look at the cost drivers or the activities that your overhead costs comprise. ABC can be pretty straightforward. This is especially true in a small- or medium-sized firm. In fact, You can probably implement a good, first-rate ABC system by taking the following four steps:

  1. Look at your overhead costs.

    Verify that you have enough overhead to be worrying about. If you're in a business with big fat margins and very low overhead, ABC may not make any sense for you. The incremental value that you achieve by more precisely allocating overhead may be simply a manifestation of an obsessive-compulsive personality disorder rather than good accounting.

  2. Identify the big overhead cost.

    You must do this if you decide that you want to allocate some or a bunch of your overhead via an ABC approach. Don't spend time trying to accurately allocate some penny-ante amounts (unless they are simple-to-allocate ones that can be done at the same time as the bigger project). Go for the biggest bang you can get for your buck. Create an ABC system that allocates, with a minimal amount of effort, a large chunk of your overhead. Don't get too pedantic.

  3. Identify the principal activities that use up the overhead costs.

    The fewer the activities you can use to do this, the easier your accounting will be. Find a handful of activities that let you fairly and accurately allocate overhead to product lines. That's the big picture.

  4. Trace the activities to products by using the appropriate measures.

    After you've identified the handful of activities that let you connect overhead expenses to products, be sure to use the appropriate measure — also known as a cost driver — to tie the overhead expenses to the product lines or service lines.

An ABC system is a tool for managing your overhead costs and the profitability of the products or services that you sell. Practically, you want to focus on the big overhead costs, and, in the end, all you really want is an ABC system that produces useful numbers — numbers that help you more clearly and creatively think about your business.

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