Activity Based Costing (ABC)

Prepared by: Jessy ChongURL: chongsk818.blogspot.com

Definition

Activity based costing (ABC) is an alternative to traditional absorption costing as a method of costing.

ABC involves the identification of the factors (cost drivers) which ‘cause’ or ‘drive’ the costs of an organisation’s major activities. Overheads are allocated and apportioned to activity cost centres or ‘cost pools’. From these activity cost centres, the overhead costs are then absorbed into the product costs on the basis of their usage of the activity. The absorption rate for each activity is a rate per unit of the relevant cost driver.

  For activity costs that seem to relate to the volume of production, the

cost driver will be volume-related (labour or machine hours).  For activity costs that do not seem to relate to production volume, a

different cost driver is identified, such as the number of production runs or number of order received.

Reason for the development of ABC The traditional cost accumulation system of absorption costing was developed in time when most

organizations produced only a narrow range of products using similar operations and consumed similar proportions of overheads, and overheads were only a very small fraction of total costs. The benefits of more accurate system for overhead allocation (using ABC) would probably have been relatively small. In addition, information processing costs were high.

  Under current situation, there has been a dramatic fall in the costs of processing information and with the

advent of advanced manufacturing technology (AMT), overheads costs rise significantly and proportion of direct production costs such as material and labour costs fall. In some cases direct costs amount to less than 5%/10% of total manufacturing cost. Therefore using traditional absorption costing based on labour cost/hours to absorb overhead costs can no longer represent a fair basis to allocate overheads costs to products.

  In addition, with the increase in range of products produced and increase in non-volume related support

activities due to the use of AMT such as set-up, production scheduling, inspection and data processing. These support activities assist 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.

  As a result, using traditional absorption costing will tend to over-allocate overhead costs to high volume

products and under-allocate overheads to low volume products with high complexity of production involving more support activities. Therefore ABC was developed to attempt to overcome this problem.

  ABC argues that traditional cost system only emphasizes the allocation of overheads costs and ignores

where the costs come from, whereas ABC examines the forces/factors behind the costs. The forces behind the overhead costs are known as cost drivers. Therefore the allocation of costs requires the understanding of cost behaviour so that appropriate cost drivers can be identified.

Conclusion:

Total costs

VC

STVC

Vary with volume

Use volume based cost driver, eg

Lhrs, Mhrs, Material Cost,

Production units

FC

LTVC

Vary with activity

Use activity based cost driver, eg

- No of production

runs

FC

Do not vary

Write of as a period cost

Outline of ABC System

Step 1 Identify an organization’s major activities that support the manufacture of the organization’s products or the provision of its services.

  Step 2 Use cost allocation and apportionment

methods to charge overhead costs to each of these activities. The costs that accumulate for each activity cost centre is called a cost pool.

  Step 3 Identify the factors which determine the size

of the costs of an activity/affect the costs of an activity. These are known as cost drivers.

  Examples of cost drivers:

Cont’d

Cost pool Possible cost driver

Ordering costs: handling customer orders Number of orders

Materials handling costs Number of production runs

Machine set-up costs Number of machine set-ups

Machine operating costs Number of machine hours

Production scheduling costs Number of production runs

Despatching costs Number of orders despatched

Cont’d

Step 4 For each cost pool/activity cost centre, calculate an absorption rate per unit of cost driver.

  Step 5 Charge overhead costs to

products for each activity, on the basis of their usage of the activity (the number of cost drivers they use). Overheads are charged by absorbing them into product costs at a rate per unit of cost driver.

Hierarchy of activities

1. Factory Cost eg, rent, rates… $x

2. Line 1 Line 2 Line 3 eg, line manager, maintenance, R&D $x

3. Product A Product B eg, design cost $x

4. Batches eg, set-up, inspection, order $x

5. Unit Cost eg, material, labour, direct expenses$x

Total Costs $xx

Hierarchy of activities can show what costs are avoidable on which level of activities are discontinued.