Activity Based Costing, Essay Example

Introduction

Activity based costing commonly abbreviated ABC refers to a type of costing model for identifying activities in an organization. The model assigns the respective costs of each activity resource to all products and services according to the consumption levels of each one of them. Thus, organizations can precisely estimate the actual costs of individual products and services so that they can eliminate those that are unprofitable and lower the costs of those which are overpriced.

In the following discussion, we review the process of activity base costing for Wal-Mart, which is a large retail store. Activity based costing is important to Walmart as it assigns the organization’s resource costs through activities to the services and products it provides to its customers.  In this organization, a number of products and services are posed to benefit immensely from activity based costing. The main service that has been selected for the purpose of this case is marketing. Essentially, activity based costing is used as a tool for enhancing understanding of product and customer cost and profitability. It can be used to support strategic decision making, measurement of production process and improvement of initiatives.

Cost Drivers

Cost drivers refer to any activity that causes a cost to be incurred.  Activity based costing approach used by Walmart tends to relate indirect costs to all those activities that drive them to be incurred. There are a number of cost drivers that are associated with operational costs and these include volume of output, number of machine hours worked, number of orders received, and number of inspections performed. In short, cost drivers can be grouped into two, namely, structural cost drivers that are derived from the organization’s strategic choices and exceptional cost drivers which are derived from the execution of business activities such as plant layout, workforce involvement, capacity utilization et cetra. In any business organization cost drivers are the real structural determinants of the cost of an activity and reflects any linkage that affects the activity.

How Walmart obtains the ABC cost.

The first step in obtaining the ABC cost involves calculating the activity overhead costs for each activity using the formulae given below;

 Bj= yearly cost of activity÷ yearly quantity x

Provided that: Bx= activity * overhead rate for x.
x = quantity of activity

The company then determines the total number of this activity x using the following equation,

Ci = Di + G(Bx)(Axi)

Where: Ci = Total annual cost of product i.
Di = Direct cost of product i.
Axi = Quantity of xj consumed by product i.
Bx= the rate of overhead in the activity x.
x = the number of the activity.
i = the quantity of the product.
G = “the sum of”.

Finally Walmart determines the products unit cost using the following derived formulae.

ABC unit cost for product i = ci ÷ units of product i.

These three steps are illustrated in following examples for Walmart Ltd, an IT company.

Annual Product Data for Walmart Ltd (Cost Is Given in Terms of $)

When one combines the company’s activities in the following cost pool based on all available data, the activity measurements associated with each cost pool can be derived as shown below;

Annual Activity Costs for Walmart Ltd

It is important to note here that most of the information produced by the activity based costing system might not be adequate enough to reduce overall operational costs because the approach tends to overlook certain underlying cost drivers such as labour rate variance.

Reference

Drucker, P.F., (1999). Management Challenges of the 21st Century. New York: Harper