Question

what are the 4 basic steps to allocate overhead to products using Activity based Costing (ABC)

Answer 1

Four basic steps to allocate overhead to products using Activity Based Costing are:

1.Identifying activities i.e. identifying major activities that take place in an organisation.

2. Assigning costs to activity cost centres i.e. assigning costs to cost pools or cost centres for each activity.

3.Selecting appropriate cost drivers i.e. identifying the factors that influence the costs of particular activities.

4.Assigning the cost of activities to products i.e.​​​ assigning such cost according to each products demand for activities.

1. Identifying Activities: The first stage is to identify the functional areas or major activities involved in the production. Examples of activities include machine related activities, divert labour related activities and various support activities like ordering, receiving, material handling, packing, despatching. Various activities are identified by carrying out activity analysis.

2. Assigning Costs to Activity Cost Centres: The second stage requires that a cost centre (also called a cost pool) be created for each activity. After the activities have been identified the cost of resources consumed over a specified period must be assigned to each activity. These costs will have to be apportioned on some suitable basis. For example the total costs of all set ups might constitute one cost centre for all setup related costs.

3. Selecting Appropriate Cost Drivers: The third stage of designing ABC system is to identify the factors that influence the cost of a particular activity. The term cost-driver is used to describe the significant determinant of the cost of the activity. The most suitable cost driver in each activity under functional areas should be identified. A cost driver is any factor that influences costs.

4. Assigning the Cost of the Activities to Products: The final stage is to trace the cost of the activities to products according to each product’s demand for these activities using cost drivers as a measure of demand. A product’s demand for the activities is measured by the number of transactions it generates for the cost driver. The cost driver should be measurable in a way that enables it to be identified with individual products.