Activity based costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity. Activity based costing is a subset of activity-based management. Activity based costing is used to determine product costs and for internal decision-making and for managing activities. Traditional Absorption costing is for external financial reporting. Activity-based costing is a suitable and appropriate method for companies with multiple products or services who are having problem of inaccurate costing information and need to know which products are really profitable and which are the one that is making loss. For these companies the effort required to successfully implement activity based costing is worth the time and resources. Activity based costing can identify high overhead costs per unit and find ways to reduce the costs, avoid decreases in head counts due to inaccurate allocation of costs, and measure profitability with higher accuracy than traditional costing that uses direct-labor hours as the only cost driver. The way it works is first major activities are identified in the process system. Next cost pools are created for groups of activities that can be allocated together. Following this cost drivers is identified. The numbers of cost drivers used vary depending on the balance between accuracy and complexity. After determining the cost drivers, rates are calculated. The rates are then applied to the respective cost drivers for each product or service that is being considered. Dividing the total cost for the product by the total product units then derives the overhead cost per unit. Overall, activity based costing has more advantages compare to traditional costing, but this method is only suitable for big company. As this method is costly and need substantial resources. By using activity based costing, it is easier to maintain low cost but high profit. Although this method has many advantages, if the user does not have enough experience, this will not a very suitable method as this is easy to be misinterpreted. Why is Activity-Based Costing Developed
Traditional costing had added a high amount of expenses into the indirect cost. However, as the percentages of indirect or overhead costs rose, traditional costing become more inaccurate, because all products did not cause indirect costs equally. For example, product A may take more time in one expensive machine than product B. but since the amount of direct labor materials might be the same, additional cost for use of the machine is not being recognized. When multiple products share common costs, there is a danger of one product subsidizing another. By using this system, managers were making decision based on inaccurate data especially where there are multiple products. Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management system. For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Instead of using high amount to allocate costs, Activity Based Costing seeks to identify cause and affect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way activity based costing often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products. Activity-based costing records the costs that traditional cost accounting does not do. Activity Based Costing provides...
References: * Kaplan, Robert S. and Bruns, W. Accounting and Management: A Field Study Perspective (Harvard Business School Press, 1987)
* Encyclopedia of Management 6th Ed. 1,066 pp. 2009.
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