Tuesday, January 12, 2010

Activity Based Costing

Activity Based Costing is a development on traditional absorption costing methods. Several developments in manufacturing have made it imperative to have a method that could more accurately deal with the problem of overheads. In the modern business environment, overheads have become a significant proportion of total production cost. This has, therefore, necessitated the need to find a method of accounting that could provide accuracy in product costing.

In the past, production was mostly manual and as such labour was a significant part of total cost of production. And, because most of the operations were labour based, material costs were also significant because of human error. That is, when work is not automated it is very likely that there would be a lot of errors and wastage during production. so, in the past overheads were an insignificant part of total production costs.

So, ABC is an approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.

Traditional cost accounting involves attributing indirect costs to individual products on the basis of an overhead absorption base related to some proxy. The proxy could be related to the usage of labour hours, machine hours, materials cost, labour cost etc. This approach provides ambiguous results in modern circumstances.

Transactions that give rise to overhead costs include: Logistical transactions; Balancing transactions; Quality transactions and Change transactions

The conditions under which ABC system analysis differs from traditional system analysis are:

  • When production overheads are high relative to direct costs, particularly direct labour. This, therefore, makes it important to use ABC in order to more accurately deal with overheads.
  • Where there is great diversity in the product range. When there is diversity it is likely that the amount of support given for the production of goods or provision of services would be high. When this is high, it implies that overheads would in turn be high.
  • Where there is considerable diversity of overhead resource input to products. Same as above.
  • When consumption of overhead resources is not driven primarily by volume. When overheads are driven by other factors other than the volume of output, it becomes imperative to use ABC. ABC would, in this case, find an appropriate driver for such overheads.

The different steps to a basic ABC process are:

Step 1: Identify the main production-related activities of the organisation.

Step 2: Identify the cost (cost pool) of each of the activities identified in Step 1.

Step 3: Determine the cost driver for each activity identified in Step 1.

Step 3a: Select the activity cost pools and cost drivers that will be used within the system.

Step 4: Calculate a cost driver rate for each activity cost pool in the same way as an overhead rate is calculated in a traditional system.

Step 5: Apply the activity cost driver rates to products (cost units) to arrive at an activity-based product cost.

The hierarchy of cost comprises the following activities: Unit-level; Batch-level; Product-level; Facility-level

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