Accounting Best Practices, Fifth Edition

9–9. Implement Activity-Based Costing

The vast majority of companies only accumulate and report on costs by department and product. The first method is tied to responsibility accounting, whereby the costs of the specific department are tied to the performance bonus of its manager. The second method assumes that the cost of overhead—mostly made up of those departmental costs noted in the first method—is assigned to products based on the amount of labor they accumulate. The problem with this approach is that the two methods should be combined so that all company costs, to the greatest extent possible, are tied to the actual cost required to produce a product. Without this information, a company is doomed to make incorrect decisions related to the correct pricing of products, or even if they should be continued or discontinued. The same problem applies to determining the cost or profit associated with each customer. Again, a company can work incorrectly to increase its business with a “high maintenance” customer that results in much lower overall profits, while abandoning other customers that are really much more profitable. Poor costing methodologies are at the bottom of many bad corporate decisions.

The solution to this problem is a system called activity-based costing. Under this approach, a company summarizes all of its costs into a number of cost pools, then allocates the expenses in those pools to a variety of activities, using a large number of allocation measures. It becomes ...