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An activity-based costing model uses activities and cost drivers to apply manufacturing overhead to manufactured goods. Companies may believe this method to be better than other manufacturing overhead application methods, giving rise to the popularity of using an activity-based costing model. To choose this model, a company should look at each activity that adds costs to a manufacturing process and define the best cost drivers that work in this system along with the ability to transfer information easily to the managerial accounting department. Other specific measures or reviews may be a part of this process as each company has slightly different manufacturing processes. Owners and executives may be the individuals who pull the trigger on the selection of this costing model.
In a manufacturing department, several different activities typically make up the entire production process. A few examples of production activities include refining raw materials, separating materials into specific groups, transforming raw materials into goods, and finishing the products for packaging. The number of activities in a production department can alter a decision on the selection of an activity-based costing model. In some cases, a company may need to break down each major activity into even smaller activities. This process helps define which activity-based costing model will work best for the company.
Other considerations for the implementation of an activity-based costing model are the cost drivers associated with each activity. A cost driver is the main application tool accountants use to apply costs from a production activity to manufactured goods. If no adequate cost driver exists in an activity, then the costing model suffers due to the lack of continuity. Standard cost drivers in an activity include labor hours, machine hours, or square feet used for a production activity. Other cost drivers may be possible to use, though accountants must carefully review these other drivers to ensure they represent accurate cost application processes.
A part of any cost accounting system is the ability to transfer information from one department to the next, with the final receiving department being the accounting office. Managerial accountants must ensure that the activity-based costing model is capable of transferring information properly through the manufacturing department and cost accounting system. Faulty information may result in poor cost application to manufactured goods. This data is necessary to properly measure the efficiency and effectiveness of a production process. This data transfer process should also be an important part of selecting an activity-based costing model.
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