Activity Based Costing (ABC)
The emergence of ABC systems
During the 1980s the limitations of traditional product costing systems began to be widely publicised. These systems were designed decades ago when most companies manufactured a narrow range of products, and direct labour and materials were the dominant factory costs. Overhead costs were relatively small, and the distortions arising from inappropriate overhead allocations were not significant. Information processing costs were high, and it was therefore difficult to justify more sophisticated overhead allocation methods.
Today companies produce a wide range of products; direct labour represents only a small fraction of total costs, and overhead costs are of considerable importance. Simplistic overhead allocations using a declining direct labour base cannot be justified, particularly when information processing costs are no longer a barrier to introducing more sophisticated cost systems. Furthermore, the intense global competition of the 1980s has made decision errors due to poor cost information more probable and more costly. Over the years the increased opportunity cost of having poor cost information, and the decreased cost of operating more sophisticated cost systems, increased the demand for more accurate product costs. It is against this background that ABC has emerged. ABC, however, is nor a recent innovation. Fifty years ago Goetz (1949) advocated ABC principles.
Some important activities & cost driver :
Number of production runs
Number of orders placed
Items in stock
Number of parts
Inspection per item
Hours of test time
Number of receiving orders
Number of packing orders
Number of store deliveries
Line item ordering
Number of line items
The main steps are
Step 1 : Identify the chosen Cost Objects
Step 2 : Identify the Direct Costs of the Products
Step 3 : Select the Cost-Apportion Bases to Use for distributing Indirect Costs to the Products
Step 4 : Identify the Costs Associated with Each Cost-Allocation Base
Step 5 : Compute the Rate per Unit of Each Cost-Allocation Base Used to the Products
Step 6 : Compute the Indirect Costs Allocated to the Products
Step 7 : Compute the Total Costs of the Products by Adding All Direct and Indirect Costs
ABC is more expensive than the traditional system. So a cost-benefit analysis is desirable. The benefits of ABC are many.
In ABC managers focus attention on activities rather than products because activities in various departments may be combined and costs of similar activities ascertained e.g. quality control, handling of materials, repairs to machines, etc
Costs are identified with activities and then allocated to products or services, based on appropriate cost drivers. So more accurate product/service costs are obtained Since overhead or indirect costs occupies a significant proportion of the total costs of the firm, the overall impact of allocation of indirect costs to products/ services more accurately is significant.
Managers manage activities and not products. Change in activities lead to changes in costs. Therefore, if the activities are managed well, costs will fall and resulting products will be more competitive.
To manage activities better and to make wiser economic decisions, managers need to identify the relationships of activities and costs in a more detailed and accurate manner.
ABC highlights problem areas that deserve management’s attention and more detailed analysis.
Weakness of ABC
ABC is not free from certain weakness. They are mentioned below:
ABC fails to...
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