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

Marginal Costing vs Absorption Costing

Marginal Costing and Absorption Costing are methods which are often used to prepare profit statements, value inventory and assist in pricing decisions. The methods have some notable differences, which can be reconciled though.

Absorption Costing absorbs all manufacturing/production costs into inventory valuation. These costs include direct material, direct labour, direct expenses,variable production overheads, as well as fixed production overheads. On the contrary, Marginal Costing absorbs only variable manufacturing/production costs into inventory.

The method chosen to cost inventory or prepare the profit statement has the potential to: affect the pattern of calculated profits; influence employee behaviour, and  provide management with relevant and useful information for planning and control purposes. And, the following could be considered to be advantages of each method.

Advantages of absorption costing:

• Gives attention to both fixed and variable costs; that is, all production costs are considered regardless of whether they are variable or fixed. And, this is very important when it comes to pricing decisions since the manufacturer can have a clear picture of the profit margin to be made on each sale, as all costs would have been incorporated into the product cost.
  
• Provides realistic periodic profits if company has a natural business cycle; profits are realistic in the sense that all production costs are matched to sales volume, rather than production volume as under Marginal Costing.
  
• It is consistent with external reporting requirements; in fact, International Accounting Standard Board recommends the use of absorption costing method over marginal costing, which is considered more useful for internal reporting.

Advantages of marginal costing:

• Distinguishes between fixed and variable costs therefore providing relevant information about costs for decision making purposes. When fixed and variable costs are split, it becomes easier to manage costs as it gets clearer to management on how costs behave. So, by altering the activity level, for instance, management can choose an optimal production level.
  

• Removes the effect of inventory changes on profit and reduces the danger of dysfunctional behaviour in employees. Dysfunctional behaviour may occur in the case of absorption costing by encouraging managers to produce more inventory than can be sold. Producing for stock has the effect of absorbing more fixed production overheads, hence reducing the cost of sale. The reduced cost of sale has the effect of improving the level of reported profits. However, it is possible for such stock to tie up capital and even become obsolete. This is dysfunctional.
  

• Avoids capitalisation of fixed overheads in unsaleable stocks. Under marginal costing, all fixed costs are treated as period costs, meaning that they are all written off in the accounting period to which they relate. So, there is no question of using inventory to defer fixed cost expenses, as might be the case with Absorption Costing.

The difference in approach by the 2 methods has implications for reported profits, especially when the inventory level is changing. The fact that absorption costing can defer fixed costs until a sale is made means that when stock level is rising it reports a higher profit than marginal costing. On the other hand, when the stock level is reducing marginal costing reports a higher profit than absorption costing. These differences in the reported profits can be reconciled by taking into account the fixed overhead absorption rate and the extent of the change in inventory.

There is, however, no clear advantage in using either absorption or marginal costing. Both have their uses and the fact that the results from both systems can be reconciled indicates that there are strong links between the two.