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Define Activity-based costing. What is an activity?

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In completing this assignment, you should probably start by explaining what activity-based costing (ABC) is. ABC is a way of allocating costs such as overhead, wages, rent, utilities, and the use of factory or workplace to the end products and services that customers purchase. As the term implies, this accounting method is based on activities, which are defined as any function that is performed in connection with producing the end product or delivering the service.

In its definition of ABC, Principlesofaccounting.com says ABC:

“Divides production into core activities, defines costs for those activities, and allocates those costs to products based on consumption of the activities.”

It might be easier to understand through examples. Say that you are considering opening a nail salon. You would need to hire manicurists who, in turn, provide manicures to your customers. Before the customer even walks through the door of your salon, there is a certain amount of prepping that must be done. For instance, the equipment and workstations must be organized and sterilized. For the purposes of ABC accounting, these would be considered “activities.” The customer does not pay for the organizing or sterilizing the workstation, but the salon pays the manicurist for the time spent on these activities. Thus, to get a true understanding of productivity and profits, the expense of these activates must be allocated properly.

Let’s look at another example. The owner of a hardware store decides to launch a promotion on gardening tools. The staff prepares a flyer, has hundreds of copies printed and distributes the flyers to local retail stores and community centers to display in their windows. As a result of this marketing initiative, in-store foot traffic to the hardware store jumps 20% and sales increase 30%. If the owner just adds the margin on the incremental sales generated, it would omit the costs spent producing the flyers.

In completing your assignment, you should note that although customers did not pay for the flyers, making and distributing them was a significant factor behind the increase in sales. The owner paid staff for their time in working on the flyers and distributing them. The owner also paid to have the flyers copied. Therefore, to get a true picture of the impact of the promotion, ABC accounting says the manager must allocate the cost of the activity – i.e. the preparation and distribution of the promotional material.

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