Using Activity-Based Costing to Allocate Indirect Costs
We just saw how companies can refine their cost allocation systems by using departmental
overhead rates. If a company wants an even more refined system, one that reduces cost
distortion to a minimum, it will use activity-based costing (ABC). Activity-based costing
(ABC) focuses on activities, rather than departments, as the fundamental cost objects.
ABC recognizes that activities are costly to perform, and each product manufactured may
require different types and amounts of activities. Thus, activities become the building
blocks for compiling the indirect costs of products, services, and customers. Companies
such as Coca-Cola and American Express use ABC to more accurately estimate the cost of
resources required to produce different products, to render different services, and to serve
different customers.
Think about the three roommates for a moment. The most equitable and accurate cost
allocation system for the roommates was one in which the roommates were charged only
for the activities in which they participated, and the extent to which they participated in
those activities. Likewise, activity-based costing generally causes the least amount of cost
distortion among products because indirect costs are allocated to the products based on the
(1) types of activities used by the product and (2) the extent to which the activities are
used.
2 Develop and use activity-based costing (ABC) to allocate indirect costs
Four Basic Steps to Computing and Using Activity Cost Allocation Rates
ABC requires the same four basic steps listed in Exhibit 4-6. The main difference between
