Imagine your company makes two types of mobile phones. They are both made using one machine. The maintenance cost of the machine is $100 a month. How much should each type of phone share in the maintenance cost? To be “fair”, some will say that the cost should be shared 50%-50%. However, what if Phone A uses 90 hours of the machine, and Phone B uses only 10 hours of the machine? Should the cost still be shared 50%-50%? This is why I found my accountant through the contractor accountants directory – I had no idea what I was doing to balance my books.
In traditional “allocated” costing, the cost should still be shared 50%-50%. But using the concept of Activity Based Costing, it should probably be split 90%-10% because one phone type uses 90 hours of the machine monthly while the other phone type only uses 10 hours of the same machine. This method uses “amount of activity” as a basis for costing, and not simply “allocation” where accountants simplistically divide the costs equally. Of course, for any product or service, there are many more activities to consider, and not simply the use of one machine.
These different activities which have an impact on cost are called “cost drivers”. Cost drivers can come in many forms such as machine hours consumed, number of inspections, hours spent on inspections, number of production runs, number of hours spent during production, number of setups, and many others. In the example above, we simply used machine hours consumed. In a more complicated example, we may also need to consider the number of inspections. What if Phone A required more inspections by company engineers than Phone B? Obviously, more of the salary of company engineers should be allocated to Phone A. On the other hand, what if Phone B required more production runs than Phone A? Again, we would not be able to simply divide general production costs between the two phone models!