06 January 2014
ACTIVITY BASED COSTING (ABC): Activity Based Costing (ABC) is an accounting methodology that assigns costs to activities rather than to products or services. This enables resources and overhead costs to be more accurately assigned to products and services that consume them. ABC assigns costs to activities based on usage of resources.
Factors prompting the development of ABC system include:
1. Growing overhead costs because of increasingly automated production 2. Increasing market competition which necessitated more accurate product costs. 3. Increased diversification to attain economies of scale and larger market share. 4. Decreasing costs of information processing because of continual improvements and increasing application of information technology. 5. Traditional costing fails to capture cause and effect relationship. The flow of activities under ABC is identified through 4 core areas: • Cost Object–It is an item for which cost measurement is required e.g. a product or a customer.
• Cost Driver–It is a factor that causes a change in the cost of an activity. There are two categories of cost driver:
• Resource Cost Driver–It is a measure of the quantity of resources consumed by an activity. It is used to assign the cost of a resource to an activity or cost pool. E.g. Staff wages, Electricity, Advertising etc.
• Activity Cost Driver–It is a measure of the frequency and intensity of demand, placed on activities by cost objects. It is used to assign activity costs to cost objects viz. a product or a customer. Eg. Inspection and testing charges, Machine set up costs, Material ordering costs, Material handling and storing costs, etc.
The various stages in ABC are: a Identification of the activities that have taken place in the organisation. The major activities in the organisation are identified. These can be Machine related activities, Direct labour related activities, and various support activities such as ordering or receiving material, handling of material etc. b Assigning costs to cost pool for each activity. c Spreading of support activities across the primary activities on suitable basis. d Determining cost driver for each activity. This is a variable which decides work volume or work load of an activity. The question that is asked is what causes the activity to incur costs? e Assigning the costs of activities to products according to product demand for activities.
Benefits of ABC: ABC is of prime importance for organisations product costing where: Production overheads are high in relation to direct costs. There is a great diversity in the product range. Products use different amounts of the overhead resources. Consumption of overhead resources is not primarily driven by volume.
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