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Activity-based costing is a managerial accounting system that allocates production costs based on manufacturing activities. This cost allocation system relies on activity cost drivers when allocating production costs. Three basic groups of cost drivers exist: volume, time, and charge-based drivers. Managerial accountants review all manufacturing activities and select an activity cost driver that best suits the production process. The measurement and review process for each cost driver ensures the company properly allocates production costs in the best manner possible.
Management accounting uses an activity cost driver to allocate overhead costs to produced goods or services. Overhead costs include indirect materials, equipment depreciation, nonproduction salaries, and similar costs. In most cases, the cost accounting system places the total cost for each of these items into one large pool. At the end of the production process, managerial accountants use the cost driver to allocate the overhead costs on a per-unit basis. This process is often quite technical and requires some detail to complete properly.
Volume-based cost drivers use a base on units of work completed. A volume-based activity cost driver experiences increasing costs as the company increases production output. An example of a volume-based cost driver is the use of direct materials for producing a single type of product. For each unit of direct material used in the production process, the activity cost driver demands at least one unit of overhead cost allocation. Other volume-based drivers work in a similar manner.
Time-based cost drivers use the length of time it takes to complete an activity for allocating production overhead costs. This type of cost driver can use different types of labor hours to allocate overhead costs. First, the time it takes to set up a production run or retool machines may be one type of time-based cost driver. Second, the number of direct labor hours used to produce one unit may also be a common type of driver. Either one uses the amount of hours spent in a certain activity to be the cost allocation basis for overhead costs.
Charge-based allocation methods are a bit less common than the previous two. Here, the cost for an entire overhead activity goes directly against the cost object. For example, equipment depreciation goes to the end product in a production activity. In some cases, the end product may not be a finished good but simply an intermediary good that moves to the next activity. Either way, the charge-based activity cost driver applies the costs all at one time.