If you make and sell products, you want to have the best information available to make decisions. One management strategy you can use to get more information is to use activity-based costing. This costing practice lets you assign your expenses to your products in a different way to get a better idea of what each inventory item actually costs to make.
Activity-Based Costing vs. Traditional System
A traditional costing system assigns your expenses to your products based on a flat rate for all expenses. If you make three products, you can choose to allocate 50% of costs to Product A, 30% to Product B, and 20% to Product C. If your total expenses of $10,000 for the month, $5,000 of this expense is the cost to make Product A. Activity-based costing allows you to use multiple rates for different expenses. The example above groups all of your costs, but this may not be accurate. Part of the costs could have been to hire a consultant that helped you for 10 hours. Under the traditional costing system above, 50% of the costs would be associated with the first product. However, the consultant might have only spent two hours helping develop this good. Activity-based costing lets you set a different rate for each type of expense so you know exactly what the cost is for each good. In the consulting example, 20% of the bill goes toward making Product A. If you use 10% of your office space to make Product A, 10% of your rent should be assigned as a cost of the product. Instead of using one flat rate to assign costs, you can choose multiple rates based on different activities.
Activity-based costing works because you choose different cost drivers. A cost driver is a variable that can be used to explain why costs happen. In the examples above, the number of hours worked by a consultant and the square footage of your office are cost drivers. Traditional costing systems only use one cost driver. Under activity-based costing, you control how many drivers you want to use. You can make your expense tracking system as complex or simple as you want. This allows you to be more detailed when looking at your costs and getting better information about your goods.
When to Use Activity-Based Costing
You can use activity-based costing when you can’t directly trace your costs to a product. If you make wooden chairs, you know the cost to make a chair includes the wood and the labour you put in. Other costs aren’t so simple to determine. How much of the overhead cost of your wood glue, nails, paint, or finish should be assigned to the chair? There’s no way to tell exactly how much is used, or it may be inefficient for you to track the costs. If you make items like dressers that use up more of these items, it’s only fair that the dresser gets assigned more of the costs. You can’t do this under a traditional costing system. Instead, use an activity-based costing system to see what expenses should be assigned to your inventory and figure out the true cost of each item you sell. Activity-based costing gives you better information, so you can price your goods correctly.