We use Activity based costing (ABC) top work out the cost per unit. This may be used for: Inventory valuation
To record costs
To price products
Absorption costing, this looks at the total production cost per unit.
Eg. Selling and distribution
Cost, advertising, cleaning,
Eg. Factory rent, electricity,
Absorption costing focuses on production costs only.
Direct materials per unit
Direct labour per unit
Production overhead per unit
Full production cost per unit
ABC has needed to be developed for a number of reasons:
Overheads driven by production in traditional manufacturing, absorption costing is based on the principal that the production overheads are driven by the level of production. The activity level can be on units, labour or machine hours. These all increase when the level of production increases. However these days businesses produce so many different products. Overheads were small in relation to other costs in traditional manufacturing, in the past such things as depreciation would have been a smaller proportion of production overheads, as production would have been more labour intensive. Leading to higher direct costs rather than indirect. Complexity and diversity of products in modern manufacturing, most companies now work in a highly competitive environment and so the products have become more complex and diverse. Eg. Cadbury now produce more than 20 chocolate bars where as the dairy milk bar is quite simple to make, the cream egg is harder and so the complexity should be taken account when deciding what drives the production overheads.
Calculating full production cost using ABC
Step 1: Group production overheads into activities, according to how they are driven. A cost pool is an activity which consumes resources and for which overhead costs are identified and allocated. For each cost pool, there should be a cost driver. The terms ‘activity’ and ‘cost pool’ are often used interchangeably. Step 2: Identify cost drivers for each activity, i.e. what causes these activity costs to be incurred. A cost driver is a factor that influences (or drives) the level of cost. Step 3: Calculate an OAR for each activity
The OAR is calculated in the same way as the absorption costing OAR. However, a separate OAR will be calculated for each activity, by taking the activity cost and dividing by the cost driver information. Step 4: Absorb the activity costs into the product
The activity costs should be absorbed back into the individual products. Step 5: Calculate the full production cost and/ or the profit or loss. Some questions ask for the production cost per unit and/ or the profit or loss per unit. Other questions ask for the total production cost and/ or the total profit or loss. Advantages and disadvantages of ABC
Provides a more accurate cost per unit. Therefore :
1. Pricing can be based on more realistic data, price based on more accurate cost data. 2. Sales strategies will be more soundly based
3. Decision making can be improved
4. Performance management can be improved.
Provides a better insight into what drive the overhead costs. Therefore management can understand overheads costs better and then they can be controlled easier. Takes into account overhead costs that are not related to production and sales volume. It can be applied to derive realistic costs in a business environment. It can be applied to all overhead costs not just production overheads. Can be used in service costing also.
Limited benefit if the overhead is a small proportion of overall cost, or overheads are primarily volume related. Impossible to allocate all overhead costs to specific activities. The choice of activities and drivers might be...
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