Finance Session - Post 13

[Nordicsupreme]

Dear Family,

Today I will be covering an important aspect in relation to Activity Based Costing
I will try to keep this post short since this is a small concept. Imagine this when you get paid your salary every month, you don't just spend money without budgeting. As the month comes to an end you have an excel sheet/notebook ready that traces majorly all the expenses you incurred during the month.
Companies do something similar. Any major business has multiple departments - Manufacturing, Research and Development , Engineering, Finance, Human Resources, Program Management, Marketing and Sales, etc. The company also manufactures a range of products - Product "A" might have Varieties like A1,A2,A3 and then there is another product namely product B with varieties like B1,B2,B3 etc. and many more products.

As you can imagine business accounting is not a simple : income minus expenses formula. Even product has a separate budget, a separate marketing campaign, a separate sales team etc. As you can understand - ever product has many cost centers, revenue centers in it. This is essential even because many products have the same raw materials and same people working in the development process, etc The raw materials and other direct costs can still be mapped with a high degree of accuracy per each product. The companies need to ascertain the overheads and indirect costs that are incurred product wise to maintain control over the profitability of the products introduced by the company.
Every product is introduced in the market by any organization with the sole purpose of making a gain from that product. One of the methods that comes in handy in such a case is known as Activity Based Costing (ABC)

Steps to using ascertaining costs based on the ABC method : (Taken from Investopedia : https://www.investopedia.com/terms/a/abc.asp )

1. Identify all the activities required to create the product.
2. Divide the activities into cost pools, which include all the individual costs related to an activity. Calculate the total overhead of each cost pool.
3. Assign each cost pool activity cost drivers, such as hours or units.
4. Calculate the cost driver rate by dividing the total overhead in each cost pool by the total cost drivers.
5. Multiply the cost driver rate by the number of cost drivers.

Cost drivers - are the factors that cause costs in a particular activity to increase. They help allocate overhead costs more accurately to products, services, or other cost objects.

Examples of Cost Drivers are :1. Direct Labor Hours The total time employees spend working on a product or service. This is often used to assign labor-related overhead costs.
2. Machine Hours: The total time machines are used in production. It is typically used to allocate machine-related overhead costs.
3. Number of Units: ProducedThe total quantity of products manufactured. It can be used to distribute production-related overhead costs.
4. Number of Production :RunsHow often a production process is set up. This helps assign costs associated with setups or batch production.
5. Area Used by the Product manufactured: The area occupied by a department, machine, or activity. This is used to allocate facility-related costs, such as rent and utilities.

A link to understand this concept better along with an example : www.youtube.com/watch?v=QaVlWoaBytQ

Thanks for reading! Hope this was helpful