Activity Based Costing

 

An alternative to absorption costing is Activity Based Costing [ABC]

 

ABC involves the identification of the factors (cost drivers) which cause the costs of an organization's major activities. Support overheads are charged to products on the basis of their usage of an activity.

 

The costs that vary with production level in the short term, the cost driver will be volume related (labour or machine hours).

 

Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction based cost drivers such as production runs or number of orders received.

Reasons for the development of ABC:

The traditional cost accumulation system of absorption costing was developed in a time when most organizations produced only a narrow range of products, so that products were underwent similar operations and consumed similar proportion of overheads. And overhead costs were only a very small fraction of total costs, direct labour and direct material costs accounting for the largest proportion of the costs. The benefits of more accurate system for overhead allocation would probably have been relatively small. In addition, information processing costs were high.

 

In recent years, there has been a dramatic fall in the costs of processing information, and with the advent of Advance Manufacturing Technology (AMT), overheads are likely to be far more important and in fact direct labour may account for as little as 5% of the production cost. It therefore now appears difficult to justify the use of direct labour or direct material as the basis for absorbing overheads or to believe that errors made in attributing overheads will not be significant.

 

Many resources are used in non-volume related support activities, such as setting up, production scheduling, inspection and data processing. These support activities assists the efficient manufacture of a wide range of products and are not, in general, affected by changes in production volume. They tend to vary in the long term according to the range and complexity of the products manufactured rather than the volume of output.

 

Thus, traditional costing system assumes that all products consumes all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products and too small a proportion of overheads to low volume products. So ABC attempts to overcome this problem.

 

Definition of ABC:

 

Activity Based Costing (ABC) involves the identification of the factors which cause the cost of an organization's major activities. Support overheads are charged to products on the basis of their usage of the factor causing the overheads.

 

The major ideas behind ABC are as follows:

 

(1) Activities cause costs. Activities includes ordering, materials handling, machining, assembly, production scheduling and dispatching.

 

(2) Producing products creates demand for the activities.

 

(3) Costs are assigned to a product on the basis of the product's consumption of the activities.

 

Outline of an ABC system:

 

An ABC system operates as follows:

 

STEP 1: Identification of major activities of organization.

 

STEP 2: Identification of the factors, which determine the size of the costs of an activity/cause the costs of an activity. Which are known as 'COST DRIVERS'.

 

STEP 3: Collect the costs associated with each cost driver into what are known as 'COST POOLS'.

 

STEP 4: Charge cost of products on the basis of their usage of the activity. A product's usage of an activity is measured by the number of activity's cost driver it generates.

 

 

Source: ACCA Study text, Paper F5, Performance Management