Activity Based Costing can be defined as an accounting methodology that assigns costs to activities based on their use of resources, rather than products or services. This enables resources and other associated costs to be more accurately attributed to the products and the services which they use. It doesn’t change or eliminate any costs; it provides detailed information about how costs are consumed. (Online manager-net.com).
Traditional cost accounting looks at what is spent, while ABC methods look at what is done in terms of activities. In ABC it is much easier to identify opportunities to reduce costs and improve performance, while maintaining the quality of care provided.
Traditional Cost Systems use cost allocation methods, do not focus on where or why costs occur, Report information that is accounting oriented and inaccurate. These systems are also not easily understood by operational managers, since the focus is fiscal. Whereas Activity Based Costing assigns costs to activities based on the resources they consume. ABC provides insights into the sources of costs and the possible impact of different decisions. It also provides the information required to take action and realize performance breakthroughs.
Implementation of Activity Based Costing
In Most cases, a company’s traditional costing account system adequately measures the direct costs of products and services, such as material and labor. As a result, ABC implementation typically focuses on indirect costs, such as manufacturing overhead and selling, general and administrative costs. (Alan Upchurch, cost accounting).
Given this, the primary goal of ABC implementation is to reclassify most indirect costs (as Specified by the traditional cost-accounting system) as direct costs. As a result of these reclassifications the accuracy of the costs is greatly increased. According to Ray H. Garrison and Eric W Noreen, there are six basic steps required to implement the ABC system:
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