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Activity-based costing (ABC) is a strategy that seeks to provide a more accurate means of assigning overhead costs in a manufacturing environment. The general idea is to identify each activity associated with the manufacturing process and allocate a cost to that activity. This approach is sometimes favored over the more traditional process of assigning costs based on the number of machine hours that are generated during the production day. In order to determine the steps for activity-based costing for a given activity, it is necessary to identify all expenses associated with that activity, then allocate those expenses to specific cost objects.
One of the key steps for activity-based costing focuses on identifying the specific activities associated with a given project or process. This is important, since doing so will provide the starting point for understanding the costs that are associated with the project in general and each activity in particular. In some cases, arranging the activities in chronological order can aid in making sure all activities are identified and accounted for before attempting to move on to any type of cost allocations.
With the range of activities identified, the steps for activity-based costing involves relating the expenses of the project to each of those activities. Many of the costs will be unique to one particular activity within the overall group of activities related to the project. The task of allocating those costs is rather straightforward, since the expenses relate only to a single activity.
Other expenses may have to do with more than one activity, making it necessary to allocate a portion of those expenses to multiple activities. This will involve assessing how much expense should be assigned to each individual activity, typically by breaking the costs into percentages that can be related to each relevant activity. Doing so helps to increase the effectiveness of the activity-based costing, since the amount of expense assigned to each activity is more accurate.
While basing cost allocation on machine hours is still common, usage of the steps for activity-based costing has increased over time. This is because increases in overall manufacturing costs have increased, making it all the more important to manage those costs effectively. In addition, many businesses tend to produce several lines of products that are manufactured simultaneously, making the process of allocating expenses to specific production lines somewhat more important than before. The various steps for activity-based costing are also helpful when the batches ran of different products varies, with some products being produced in large batches while others are produced in smaller lots.
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