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How can you determine cost drivers for each department with activity-based costing?

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Activity-based costing (ABC) is a method of allocating indirect costs to products or services based on the activities they consume. It can help you improve your profitability, pricing, and decision-making by providing more accurate and relevant information about your cost structure. However, to implement ABC, you need to identify the cost drivers for each department that perform activities for your products or services. Cost drivers are the factors that cause or influence the amount of resources used by an activity. In this article, you will learn how to determine cost drivers for each department with ABC.

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CA HENCY SHAH ????

??FCA | ??M.Com (F&T) | ??16x LinkedIn Top Voice | ???Information System Auditor | ??Certified Forensic Accountant…
Tomi Akinwale ACCA, ACA, ACTI, B.TECH, FMVA, AAT.

Tax | Deloitte | Financial Reporting & Modelling |

1 Assess your current costing system

Before you start identifying cost drivers, you need to evaluate your current costing system and identify its limitations and problems. For example, you may be using a traditional costing system that allocates overhead costs based on a single volume-based driver, such as direct labor hours or machine hours. This can result in inaccurate and distorted cost information, especially if you have a diverse product mix, complex processes, or high overhead costs. You may also be using a departmental costing system that assigns overhead costs to each department based on its own allocation base, such as direct materials or direct labor. This can result in double-counting or under-counting of costs, especially if there are interdepartmental transfers or shared resources. You should analyze how your current costing system affects your profitability, pricing, and decision-making, and identify the areas where you need more accurate and relevant cost information.

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CA HENCY SHAH ????

??FCA | ??M.Com (F&T) | ??16x LinkedIn Top Voice | ???Information System Auditor | ??Certified Forensic Accountant | ??Certified Concurrent Auditor | ??Virtual CFO | ??Researcher | ??16K+ Family | ??800K+ Impressions
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Understanding cost drivers is crucial for effective cost allocation within departments, especially with activity-based costing (ABC) methodology. One approach involves dissecting departmental activities to identify what truly impacts costs. By examining resource consumption patterns and their relationship to activities, we can pinpoint key cost drivers. This enables a more precise allocation of overhead expenses, facilitating better decision-making and resource optimization within each department.

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junaid ali khan

Senior Marketing services Executive at Bosch Pharmaceuticals Pakistan
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Determining departmental cost drivers with activity-based costing involves identifying activities, allocating costs, and pinpointing specific cost influencers. By measuring usage of these drivers and analyzing departmental costs, organizations can target cost reduction efforts effectively. Continuously refining methods ensures accuracy and informs decision-making for operational improvement.

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SYED DANIAL ALI ??? ?????? ???

Strategic Accounting & Finance Leader | Policy Development Specialist | Diverse Team Builder | Process Transformer
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Analyzing Cost Behavior: Examine the behavior of costs within each department to identify potential cost drivers. Differentiate between fixed, variable, and semi-variable costs to select appropriate drivers that accurately reflect the underlying cost dynamics. Engaging Departmental Stakeholders: Collaborate with departmental managers and employees to gain insights into the operations and resource consumption patterns. By involving stakeholders, you can ensure that the selected cost drivers are practical, relevant, and reflective of the department's activities, fostering buy-in and acceptance of the activity-based costing approach.

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2 Identify the activities and cost pools

The next step is to identify the activities and cost pools for each department that performs activities for your products or services. Activities are tasks or processes that consume resources and generate costs, while cost pools are groups of costs related to a specific activity or cost driver. For example, in a manufacturing department, material handling may involve the costs of moving, storing, and inspecting materials, while machine setup involves the costs of preparing and adjusting machines for production. Additionally, quality control requires the costs of inspecting and testing products for quality standards, and maintenance requires the costs of repairing and servicing machines and equipment. All of these activities and cost pools should be classified into four categories: unit-level, batch-level, product-level, and facility-level. Unit-level activities and cost pools are related to the production of each unit of product or service; batch-level activities and cost pools are connected to producing a group or batch of units; product-level activities and cost pools are linked to designing, developing, and supporting a specific product or service; and facility-level activities and cost pools relate to the general operation and maintenance of the facility.

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Tomi Akinwale ACCA, ACA, ACTI, B.TECH, FMVA, AAT.

Tax | Deloitte | Financial Reporting & Modelling |
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Identify the activities and pools by listing all the major steps involved in bringing a product or service to your customers. This includes research and development, design, production, marketing, sales, and customer service.

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3 Select the cost drivers

The final step is to select the cost drivers for each activity and cost pool. Cost drivers are factors that cause or influence the amount of resources used by an activity, and they should be measurable, relevant, and controllable. In a manufacturing department, some examples of cost drivers are material handling, machine setup, quality control, and maintenance. You should choose the cost drivers that best reflect the cause-and-effect relationship between the activity and the cost pool. Additionally, you should avoid using volume-based drivers such as direct labor hours or machine hours for non-unit-level activities and cost pools. Too many or too few cost drivers can also lead to complexity or oversimplification of your costing system. By following these steps, you can determine the cost drivers for each department with ABC and improve your cost allocation and management. Ultimately, this can help you better understand your cost structure, enhance your profitability, pricing, and decision-making, and gain a competitive advantage in your market.

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4 Here’s what else to consider

This is a space to share examples, stories, or insights that don’t fit into any of the previous sections. What else would you like to add?

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How can you determine cost drivers for each department with activity-based costing?

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1 Assess your current costing system

2 Identify the activities and cost pools

3 Select the cost drivers

4 Here’s what else to consider

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