Cost allocation model: Implementing Activity Based Cost Allocation: Best Practices

1. What is cost allocation and why is it important for businesses?

cost allocation is the process of assigning the costs of various activities and resources to the products, services, or customers that consume them. It is a crucial tool for businesses to measure and improve their performance, profitability, and efficiency. Cost allocation can help businesses to:

1. understand the true cost and value of their offerings. By allocating costs to the outputs that generate them, businesses can determine the profitability of each product, service, or customer segment. This can help them to make informed decisions about pricing, marketing, and resource allocation. For example, a company that produces and sells furniture may allocate the costs of materials, labor, machinery, and overhead to each product line, such as chairs, tables, sofas, etc. This can help the company to identify which products are more or less profitable, and adjust their strategy accordingly.

2. Optimize their processes and operations. By allocating costs to the activities that incur them, businesses can identify and eliminate waste, inefficiency, and redundancy. This can help them to improve their quality, productivity, and competitiveness. For example, a hospital may allocate the costs of medical staff, equipment, supplies, and utilities to each service or procedure, such as surgery, diagnosis, treatment, etc. This can help the hospital to identify which services or procedures are more or less costly, and find ways to reduce or avoid unnecessary expenses.

3. align their goals and incentives. By allocating costs to the units or departments that are responsible for them, businesses can create a culture of accountability and transparency. This can help them to motivate and reward their employees, managers, and stakeholders for achieving their objectives and contributing to the overall success of the business. For example, a university may allocate the costs of faculty, facilities, administration, and research to each academic program, such as engineering, business, arts, etc. This can help the university to evaluate the performance and impact of each program, and allocate resources and recognition accordingly.

2. How are they done and what are their limitations?

Before discussing the best practices for implementing activity-based cost allocation, it is important to understand the traditional methods of cost allocation and their limitations. traditional cost allocation methods are based on the assumption that costs are driven by the volume of output or the consumption of resources. These methods assign costs to products or services using a single or a few cost drivers, such as direct labor hours, machine hours, or sales revenue. The most common traditional cost allocation methods are:

1. Direct method: This method allocates all the costs of the support departments (such as administration, human resources, or maintenance) directly to the operating departments (such as production or sales) based on a predetermined allocation rate. For example, if the total cost of the administration department is $100,000 and the total direct labor hours of the production department is 10,000, then the allocation rate is $10 per direct labor hour. The production department will receive an allocation of $100,000 from the administration department.

2. Step-down method: This method allocates the costs of the support departments to the operating departments and to other support departments in a sequential order. The order is usually based on the degree of service provided by the support departments to each other. Once a support department's costs are allocated, they are not reallocated to other departments. For example, if the administration department provides more service to the human resources department than to the maintenance department, then the administration department's costs are allocated first to the human resources department, then to the maintenance department, and finally to the operating departments.

3. Reciprocal method: This method allocates the costs of the support departments to the operating departments and to other support departments in a simultaneous manner. This method recognizes the mutual interdependencies among the support departments and allocates the costs using a system of equations or a matrix. For example, if the administration department provides 10% of its service to the human resources department and the human resources department provides 20% of its service to the administration department, then the reciprocal method will allocate the costs of both departments to each other and to the operating departments.

However, these traditional methods have several limitations that affect the accuracy and usefulness of the cost information. Some of the limitations are:

- They ignore the diversity and complexity of the activities performed by the support departments and the operating departments. For example, the administration department may perform different activities for different operating departments, such as payroll, accounting, or legal services. However, the traditional methods allocate the same rate of the administration department's costs to all the operating departments, regardless of the type and amount of activities they consume.

- They use arbitrary and simplistic cost drivers that do not reflect the actual consumption of resources by the products or services. For example, direct labor hours may not be a good indicator of the cost of the production department, especially if the production process is automated or involves different levels of skill and complexity. Similarly, sales revenue may not be a good indicator of the cost of the sales department, especially if the sales activities vary by product, customer, or market segment.

- They distort the product or service costs and profitability by overcosting or undercosting some products or services. For example, if a product consumes a high proportion of the support department's costs but a low proportion of the volume-based cost driver, then the traditional methods will undercost the product and overstate its profitability. Conversely, if a product consumes a low proportion of the support department's costs but a high proportion of the volume-based cost driver, then the traditional methods will overcost the product and understate its profitability.

These limitations of the traditional cost allocation methods can lead to poor decision making, such as pricing, product mix, outsourcing, or budgeting decisions. Therefore, it is necessary to adopt a more refined and realistic cost allocation method that can capture the causal relationships between the costs and the activities that drive them. This is where activity-based cost allocation comes in. Activity-based cost allocation is a method that assigns costs to products or services based on the activities they require and the resources they consume. This method can provide more accurate and relevant cost information that can help managers make better decisions and improve the performance of the organization. The next section will discuss the best practices for implementing activity-based cost allocation.

3. What is it and how does it differ from traditional methods?

One of the most important decisions in cost management is how to allocate costs to different products, services, or customers. Traditionally, cost allocation has been based on simple criteria such as direct labor hours, machine hours, or sales volume. However, these methods may not reflect the true consumption of resources by each cost object, especially in complex and diversified businesses. Therefore, a more refined and accurate approach is needed: activity-based cost allocation.

Activity-based cost allocation is a method that assigns costs to cost objects based on the activities that they require. Activities are the processes or tasks that consume resources and generate costs. For example, ordering materials, setting up machines, inspecting products, or delivering goods are all activities that incur costs. By identifying the activities that each cost object demands, and measuring the amount of resources consumed by each activity, activity-based cost allocation can provide a more realistic and fair distribution of costs.

There are several benefits of using activity-based cost allocation over traditional methods. Some of them are:

- It improves the accuracy and relevance of cost information, which can help managers make better decisions about pricing, product mix, outsourcing, process improvement, and profitability analysis.

- It enhances the visibility and accountability of cost drivers, which can motivate managers and employees to reduce waste, improve efficiency, and optimize resource utilization.

- It supports the implementation of other management tools and techniques, such as activity-based budgeting, activity-based management, and balanced scorecard.

However, activity-based cost allocation also has some limitations and challenges. Some of them are:

- It requires a lot of data collection and analysis, which can be time-consuming, costly, and complex. It may also involve subjective judgments and assumptions, which can affect the reliability and validity of the results.

- It may not be suitable for all types of businesses or industries, especially those that have low overhead costs, high product diversity, or frequent changes in activities and processes.

- It may create resistance and conflict among managers and employees, who may perceive the new system as unfair, complex, or threatening.

To implement activity-based cost allocation successfully, some best practices are:

- Involve top management and key stakeholders in the design and implementation process, and communicate the objectives, benefits, and expectations clearly and frequently.

- Conduct a thorough analysis of the business processes and activities, and identify the most relevant and significant cost drivers and cost pools.

- Use appropriate and reliable data sources and methods to measure the activity costs and the activity consumption by each cost object.

- Review and update the system periodically to reflect the changes in the business environment and the feedback from the users.

- Provide adequate training and support to the managers and employees who will use the system, and monitor and evaluate the performance and outcomes.

An example of activity-based cost allocation is:

- A company produces two products: A and B. The company has three activities: ordering materials, setting up machines, and inspecting products. The total overhead costs for the year are $120,000. The following table shows the cost drivers, cost pools, and activity rates for each activity:

| Activity | cost Driver | cost Pool | Activity Rate |

| Ordering materials | Number of orders | $30,000 | $500 per order |

| Setting up machines | Number of setups | $60,000 | $1,000 per setup |

| Inspecting products | Number of inspections | $30,000 | $100 per inspection |

- The following table shows the activity consumption by each product:

| Product | Number of orders | Number of setups | Number of inspections |

| A | 20 | 40 | 200 |

| B | 40 | 20 | 100 |

- The activity-based cost allocation for each product is calculated as follows:

| Product | Ordering materials | Setting up machines | Inspecting products | Total overhead costs |

| A | 20 x $500 = $10,000 | 40 x $1,000 = $40,000 | 200 x $100 = $20,000 | $70,000 |

| B | 40 x $500 = $20,000 | 20 x $1,000 = $20,000 | 100 x $100 = $10,000 | $50,000 |

- The traditional cost allocation for each product, based on direct labor hours, is calculated as follows:

| Product | Direct labor hours | Overhead rate | Total overhead costs |

| A | 1,000 | $120,000 / 2,000 = $60 per hour | 1,000 x $60 = $60,000 |

| B | 1,000 | $120,000 / 2,000 = $60 per hour | 1,000 x $60 = $60,000 |

- The difference between the activity-based cost allocation and the traditional cost allocation for each product is:

| Product | Activity-based cost allocation | Traditional cost allocation | Difference |

| A | $70,000 | $60,000 | +$10,000 |

| B | $50,000 | $60,000 | -$10,000 |

- The difference shows that product A is undercosted and product B is overcosted by the traditional method, which may lead to distorted pricing and profitability decisions. By using activity-based cost allocation, the company can obtain more accurate and relevant cost information, and adjust its strategies accordingly.

4. How can it improve accuracy, efficiency, and profitability of businesses?

One of the main advantages of activity-based cost allocation is that it can improve the accuracy, efficiency, and profitability of businesses by providing a more realistic picture of how resources are consumed and how costs are generated. Activity-based cost allocation assigns costs to activities based on the resources they use, and then allocates costs to products or services based on the activities they require. This way, activity-based cost allocation can capture the complexity and diversity of business operations and reflect the true cost drivers of each product or service. Some of the benefits of activity-based cost allocation are:

- It can help identify and eliminate non-value-added activities that waste resources and increase costs. For example, a company that uses activity-based cost allocation may discover that it spends a lot of time and money on rework, inspection, or customer complaints due to poor quality. By reducing or eliminating these activities, the company can save costs and improve quality.

- It can help optimize the use of resources and improve efficiency. For example, a company that uses activity-based cost allocation may find out that it has excess capacity in some activities and underutilized capacity in others. By reallocating resources to match the demand for each activity, the company can increase its output and reduce its costs per unit.

- It can help enhance the profitability of products or services by providing more accurate and relevant information for pricing, product mix, and customer profitability decisions. For example, a company that uses activity-based cost allocation may realize that some of its products or services are overpriced or underpriced based on their true costs and value. By adjusting the prices to reflect the costs and benefits of each product or service, the company can increase its revenue and profit margin. Similarly, the company may also identify which products or services are more or less profitable and decide to increase or decrease their production or promotion accordingly. Additionally, the company may also segment its customers based on their profitability and tailor its marketing and service strategies to each segment.

5. What are the common obstacles and pitfalls of implementing it?

Activity-based cost allocation (ABC) is a method of assigning costs to products or services based on the activities they consume. ABC can provide more accurate and relevant information for decision-making, performance evaluation, and process improvement. However, implementing ABC is not without challenges. Some of the common obstacles and pitfalls of ABC are:

- Data collection and validation: ABC requires a lot of data on the activities, resources, and cost drivers of each product or service. Collecting and validating this data can be time-consuming, costly, and prone to errors. For example, if the data on the number of hours spent by employees on different activities is inaccurate, the ABC results will be distorted.

- Complexity and overhead: ABC involves identifying and measuring numerous activities, resources, and cost drivers. This can increase the complexity and overhead of the costing system, making it difficult to maintain and update. For example, if the organization changes its processes, products, or services, the ABC system may need to be revised accordingly.

- Resistance and skepticism: ABC may face resistance and skepticism from managers and employees who are used to the traditional costing methods. ABC may reveal that some products or services are over- or under-costed, which may have implications for pricing, profitability, and resource allocation. For example, if ABC shows that a product is less profitable than previously thought, the managers may have to reconsider its pricing strategy or even discontinue it.

- Integration and alignment: ABC may not be compatible or aligned with the existing accounting and information systems of the organization. ABC may require different definitions, classifications, and measurements of costs and activities than the conventional systems. For example, if ABC uses different cost pools and allocation bases than the financial accounting system, the ABC results may not be consistent with the financial statements.

6. How have some businesses applied it and what were the results?

Activity-based cost allocation is a method of assigning costs to products or services based on the activities they require. This way, the costs reflect the actual consumption of resources by each product or service, rather than being averaged or arbitrarily allocated. Activity-based cost allocation can help businesses improve their profitability, efficiency, and competitiveness by providing more accurate and relevant information for decision making.

Some examples of how businesses have applied activity-based cost allocation and what were the results are:

- A manufacturing company that produces different types of furniture used activity-based cost allocation to identify the cost drivers of each product line, such as materials, labor, machine hours, setup time, quality control, and shipping. By doing so, the company was able to determine the profitability of each product and customer segment, and adjust its pricing and production strategy accordingly. The company also reduced its overhead costs by eliminating or outsourcing some of the non-value-added activities.

- A hospital that provides various medical services used activity-based cost allocation to allocate the costs of its departments, such as surgery, pharmacy, laboratory, and radiology, to the patients who used them. By doing so, the hospital was able to improve its cost management and reimbursement processes, and identify the areas where it could improve its efficiency and quality of care. The hospital also increased its patient satisfaction by providing more transparent and accurate billing statements.

- A software company that develops and sells different types of software products used activity-based cost allocation to allocate the costs of its development, marketing, sales, and support functions to the products they supported. By doing so, the company was able to measure the profitability and performance of each product and customer segment, and allocate its resources and investments more effectively. The company also enhanced its innovation and customer loyalty by focusing on the products and features that added the most value to the customers.

7. List the sources of information and data used in the blog

The information and data used in this blog are based on reliable sources that have been cited throughout the article. These sources include academic journals, books, reports, and websites that provide relevant and credible insights on the topic of cost allocation model and activity-based costing. The following is a list of the main sources that have been consulted and referenced in this blog:

- Cooper, R., & Kaplan, R. S. (1988). Measure costs right: make the right decisions. harvard business review, 66(5), 96-103. This is the seminal article that introduced the concept of activity-based costing and its advantages over traditional costing methods. It explains how activity-based costing assigns costs to products or services based on the activities they consume, rather than the volume or quantity they produce. It also illustrates how activity-based costing can help managers make better decisions about product mix, pricing, outsourcing, and process improvement.

- Turney, P. B. (1991). Common cents: the ABC performance breakthrough. Cost Technology. This is a comprehensive book that covers the theory and practice of activity-based costing and its applications in various industries and sectors. It provides detailed guidance on how to implement activity-based costing, how to identify and measure activities and cost drivers, how to allocate costs to products or services, and how to use activity-based costing for performance measurement and improvement. It also includes many case studies and examples that demonstrate the benefits and challenges of activity-based costing.

- Kaplan, R. S., & Anderson, S. R. (2007). time-driven activity-based costing: a simpler and more powerful path to higher profits. Harvard Business Press. This is a recent book that proposes a new approach to activity-based costing that simplifies the process and improves the accuracy of cost allocation. It introduces the concept of time-driven activity-based costing, which uses the time required to perform each activity as the basis for cost allocation, rather than the number of transactions or events. It also shows how time-driven activity-based costing can be integrated with other management tools, such as balanced scorecard, lean management, and value stream mapping.

- https://www.accountingtools.com/articles/2017/5/15/activity-based-costing This is a website that provides a concise and clear overview of activity-based costing, its advantages and disadvantages, its steps and methods, and its examples and applications. It also offers a comparison between activity-based costing and traditional costing, and explains the differences and similarities between activity-based costing and activity-based management. It is a useful resource for anyone who wants to learn the basics of activity-based costing or refresh their knowledge on the topic.

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