Activity-based Costing (ABC)

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Activity-based Costing (ABC)

An activity-based approach refines a costing system by focusing on individual activities as the fundamental cost objects. It uses the cost of these activities as the basis for assigning costs to other cost objects such as products or services.

There are four levels of a cost hierarchy:
1- Output unit-level costs: costs of activities performed on each individual unit of a product or service. 2- Batch-level costs: costs of activities related to a group of units of products or services rather than to each individual unit of product or service. 3- Product-sustaining costs or service-sustaining costs: costs of activities undertaken to support individual products or services regardless of the number of units or batches in which the units are produced. 4- Facility-sustaining costs: costs of activities that cannot be traced to individual products or services but support the organization as a whole.

|Activity center |Unit-level |Batch-level |Product-level |Facility-level | | |Activity |Activity |Activity |Activity | |Parts inventory management. | | |× | | |Labour-related |× | | | | |Plant occupancy | | | |× | |Purchase order | |× | | | |Machine-related |× | | | | |General factory | | | |× | |Product prototype testing | | |× | | |Production orders | |× | | | |Product design | | |× | | |Machine setup | |× | | | |Personal administration | | | |× |

It is important to classify costs into a cost hierarchy because costs in different cost pools relate to different cost-allocation bases and not all cost-allocation bases are unit-level. For example, an allocation base like setup hours is a batch-level allocation base, and design hours is a product-sustaining base, both insensitive to the number of units in a batch or the number of units of product produced. If costs were not classified into a cost hierarchy, the alternative would be to consider all costs as unit-level costs, leading to misallocation of those costs that are not unit-level costs.

An ABC approach focuses on activities as the fundamental cost objects. The costs of these activities are built up to compute the costs of products, and services, and so on. Simple costing systems have one or a few indirect cost pools, irrespective of the heterogeneity in the facility while ABC systems have multiple indirect cost pools. An ABC approach attempts to use cost drivers as the allocation base for indirect costs, whereas a simple costing system generally does not. The ABC approach classifies as many indirect costs as direct costs as possible. A simple costing system has more indirect costs.

The main costs and limitations of ABC are the measurements necessary to implement the systems. Even basic ABC systems require many calculations to determine costs of products and services. Activity-cost rates...
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