There are several costing models used in business, and transaction-based costing is one of them. In an activity-based costing, the various activities in the organization are identified and assigned on a cost basis.
When it comes to the prices of the products and services produced by the company, the cost of the activity is calculated for the actions that have been performed in the process of producing the products and services. In other words, activity-based costing assigns indirect costs to direct costs. These indirect costs are also known as overhead costs in the business world.
Let's take an example. There are a number of activities performed in a business organization, and these activities apply to many departments and phases, such as planning, manufacturing, or engineering. All of these actions ultimately contribute to the production of products or the provision of services to end customers.
The quality control activities of a garment company are one of the perfect examples of such activities. By determining the cost of a quality control function, management can recognize the cost of each product, service, or resource. This understanding helps executive management manage the business organization seamlessly.
Calculating costs by type of activity is more effective when used in the long term rather than the short term.
Implementation in the organization
When it comes to implementing performance-based costs in an organization, the commitment of senior management is a must. Calculating costs based on activity requires visionary leadership that must endure a long-term perspective. Consequently, it is required that senior management fully understand how activity-based costing works and how management interacts with the process.
Before implementing cost-based activities, it is always a good idea for the entire organization to conduct a trial run. The best candidate for this pilot run is a department that suffers from a lack of profits.
While this may be considered risky, such departments may be able to succeed if they are managed at a cost-based basis. Finally, it would give the organization a measurable illustration of costs based on the activity and its success. In the event that no cost savings occur after the pilot study, it is most likely that the model has not been implemented properly or the model is not suitable for the department or the company as a whole.
Having a core team is important
If an organization plans to increase costs based on activities, putting a core team into operation is a big advantage. If the organization is small, you can hire a team with the help of volunteers who will devote their time on a part-time basis. This group is responsible for identifying and evaluating actions that need to be reviewed in order to optimize a product or service.
Ideally, the team should consist of professionals from all practices in the organization. However, hiring an outside consultant can also be a plus.
Software
When implementing costing based on the activities of the organization, it is advantageous to use computer software for calculations and data storage. Computer software can be a simple database that will store information such as specialized ABC software for an organization or off-the-shelf general-purpose software.
Procedure
The procedure for successful implementation in an organization of activity-based costing is as follows:
Identify the team responsible for implementing activity-based costing.
The team identifies and evaluates activities related to relevant products and services.
The team selects a subset of the actions that you want to perform to calculate costs based on the work.
The team identifies items of selected actions that cost too much money for the organization. At this stage, the team should pay attention to the details, as many actions can protect their cost and may look innocent from the outside.
Fixed and variable costs associated with the activity have been determined.
The collected cost information will be entered into the ABC software.
The software then performs calculations and generates reports to support management decisions.
Based on these reports, management can determine the steps that need to be taken to increase profits in order to make the operation more efficient.
Identify the team responsible for implementing activity-based costing.
The team identifies and evaluates activities related to relevant products and services.
The team selects a subset of the actions that you want to perform to calculate costs based on the work.
The team identifies items of selected actions that cost too much money for the organization. At this stage, the team should pay attention to the details, as many actions can protect their cost and may look innocent from the outside.
Fixed and variable costs associated with the activity have been determined.
The collected cost information will be entered into the ABC software.
The software then performs calculations and generates reports to support management decisions.
Based on these reports, management can determine the steps that need to be taken to increase profits in order to make the operation more efficient.
Management steps and decisions taken after estimating activity-based costs are commonly referred to as performance-based management. In this process, management makes business decisions to optimize certain activities and allows some actions to go.
Things you need to know
Sometimes organizations face the risk of spending too much time, money, and resources collecting and analyzing the data needed for an activity-based cost model. This can eventually lead to frustration, and the organization may eventually abandon ABC.
Failure to link the results of cost-based calculations usually hinders successful implementation. This usually happens when decision-makers are unaware of the "big picture" of how activity-based costs can be used throughout an organization. Understanding the concepts and actively participating in the ABC implementation process can easily eliminate this.
If a business organization requires quick fixes, calculating costs based on activity will not be the correct answer. Therefore, ABC should not be used in situations where a quick win is required.
Conclusion
Calculating costs by type of activity is another way to estimate the costs of an organization in order to optimize the level of profit.
If ABC is implemented with the right understanding for the right purpose, it can return greater long-term value to the organization.
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