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ABC

Activity-based costing (ABC) is a method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. It assigns overheads to cost objects based on cost drivers such as volume, time, and complexity. ABC provides more accurate product costs than traditional costing systems and helps improve decision-making.

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0% found this document useful (0 votes)
121 views13 pages

ABC

Activity-based costing (ABC) is a method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. It assigns overheads to cost objects based on cost drivers such as volume, time, and complexity. ABC provides more accurate product costs than traditional costing systems and helps improve decision-making.

Uploaded by

Sunil Bodo Raito
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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Definition:

ABC has been defined by CIMA as ‘cost attribution to cost units on the
basis of benefit received from indirect activities e.g. ordering setting up,
assuring quality’. According to Horngren, Foster and Datar ‘ABC is not
an alternative costing system to job costing or process costing. Rather
ABC is an approach to developing the cost numbers used in job costing
or process costing systems. The distinctive feature of ABC is its focus on
activities as the fundamental cost objects. In contrast most traditional
approaches used in job and process costing systems rely on general
purpose accounting systems, not tailored to the activities found in
individual organisations. The ABC approach has the potential to provide
managers with information they find more useful for costing purposes’.
Activity Based Costing is based on the belief that in production process
there are various activities which give rise to costs. ABC creates a link
between activities and products by assigning a cost of activities to
products based on an individual product.

According to Dansby and Lawrence ‘In ABC costs are not initially traced
to departments. Instead, costs are first traced to activities and then to
products: Activities causing overheads (or cost drivers) are identified.
These activities are later used as a base for allocating overhead costs to
products.

Introduction of ABC System:

ABC system assumes that activities cause costs and also that products
create demands for activities. The system recognizes that businesses
must understand the factors that drive each major activity, the cost
activities and how activities relate to products.

The design of ABC system involves following stages:

(1) Identifying activities i.e. identifying major activities that take place in
an organisation.

(2) Assigning costs to activity cost centres i.e. assigning costs to cost
pools or cost centres for each activity.

(3) Selecting appropriate cost drivers i.e. identifying the factors that
influence the costs of particular activities.

(4) Assigning the cost of activities to products i.e. assigning such cost
according to each products demand for activities.

These stages may be considered in detail:


1. Identifying Activities:

The first stage is to identify the functional areas or major activities


involved in the production. Examples of activities include machine
related activities, divert labour related activities and various support
activities like ordering, receiving, material handling, packing,
despatching. Various activities are identified by carrying out activity
analysis. The activities may be basically fall into four categories as
suggested by Cooper and Kaplan’.

(a) Unit Level Activities or Primary Activities:

The cost of primary activities (like use of indirect materials and


consumables, testing of every item produced) may be correlated to
number of units produced (i.e. on volume-basis).

(b) Batch Level Activities:

These are manufacturing support activities (like material ordering,


machine set-up costs, inspection of products etc). The cost of such
activities is driven by number of batches of units produced.

(c) Product Level Activities:

Activities like designing of the product, keeping technical drawings of


product, activities upto date, advertising of a specific product are called
product level. The cost of these activities is driven by the creation of a
new product line and its maintenance.

(d) Facility Level Activities:

Certain activities cannot be related to a particular product, instead may


be related to certain facilities like maintaining the building, security of
plant, salaries of production manager, advertisement to promote
organisation.
It may be noted that unit level activities and facility level activities are
the same as those in traditional absorption costing which will be
allocated on physical volume basis, ABC will be more useful if there is
significant size of batch level and product level activities.

2. Assigning Costs to Activity Cost Centres:

The second stage requires that a cost centre (also called a cost pool) be
created for each activity. After the activities have been identified the
cost of resources consumed over a specified period must be assigned to
each activity. These costs will have to be apportioned on some suitable
basis. For example the total costs of all set ups might constitute one
cost centre for all setup related costs.

3. Selecting Appropriate Cost Drivers:

The third stage of designing ABC system is to identify the factors that
influence the cost of a particular activity. The term cost-driver is used to
describe the significant determinant of the cost of the activity. The
most suitable cost driver in each activity under functional areas should
be identified. A cost driver is any factor that influences costs.

The main functional areas are:

(i) Material Management

(ii) Stores Management

(iii) Production Management

(iv) Quantity Control Management

(v) Personnel Management

(vi) Sales Management


(vii) Repairs and Maintenance

(viii) Administration and

(ix) Public Relations.

4. Assigning the Cost of the Activities to Products:

The final stage is to trace the cost of the activities to products according
to each product’s demand for these activities using cost drivers as a
measure of demand. A product’s demand for the activities is measured
by the number of transactions it generates for the cost driver. The cost
driver should be measurable in a way that enables it to be identified
with individual products.

Advantages of Activity Based Costing (ABC):

The following are the advantages of ABC:

1. Accurate Product Cost:

ABC brings accuracy and reliability in product cost determination by


focusing on cause and effect relationship in the cost incurrence. It
recognises that it is activities which cause costs, not products and it is
product which consume activities. In advanced manufacturing
environment and technology where support functions overheads
constitute a large share of total costs, ABC provides more realistic
product costs.

ABC produces reliable and correct product cost data in case of greater
diversity among the products manufactured such as low-volume
products, high-volume products. Traditional costing system is likely to
bring errors and approximation in product cost determination due to
using arbitrary apportionment and absorption methods.
2. Information about Cost Behaviour:

ABC identifies the real nature of cost behaviour and helps in reducing
costs and identifying activities which do not add value to the product.
With ABC, managers are able to control many fixed overhead costs by
exercising more control over the activities which have caused these
fixed overhead costs. This is possible since behaviour of many fixed
overhead costs in relation to activities now become more visible and
clear.

3. Tracing of Activities for the Cost Object:

ABC uses multiple cost drivers, many of which are transaction based
rather than product volume. Further, ABC is concerned with all
activities within and beyond the factory to trace more overheads to the
products.

4. Tracing of Overhead Costs:

ABC traces costs to areas of managerial responsibility, processes,


customers, departments besides the product costs.

5. Better Decision Making:

ABC improves greatly the manager’s decision making as they can use
more reliable product cost data. ABC helps usefully in fixing selling
prices of products as more correct data of product cost is now readily
available.

6. Cost Management:

ABC provides cost driver rates and information on transaction volumes


which are very useful to management for cost management and
performance appraisal of responsibility centres. Cost driver rates can be
used advantageously for the design of new products or existing
products as they indicate overhead costs that are likely to be applied in
costing the product.

7. Use of Excess Capacity and Cost Reduction:

ABC, through the processes of pooling of activity costs and the


identification of cost drivers, can lead to a range of applications. These
include the identification of spare capacity and the fostering of cost
reduction by comparing the resources required under ABC with the
resources that are currently provided. This provides a platform for the
development of activity-based budgeting in which the resource
relationships identified by ABC are used to project future resource
requirements.

8. Benefit to Service Industry:

Service organizations, such as banks, hospitals and government


departments, have very different characteristics than manufacturing
firms. Service organizations have almost no direct costs, most of the
costs are overheads and they do not hold stocks of service as the
service is consumed when it is produced. Traditional costing has
generally been considered inappropriate for these organizations,
whereas ABC offers the potential of benefits from improved decision
making and cost management.

Demerits of Activity Based Costing (ABC):

The following are the demerits of ABC:


1. Expensive and Complex:

ABC has numerous cost pools and multiple cost drivers and therefore
can-be more complex than traditional product costing systems. It can
prove costly to manage ABC system.

2. Selection of Drivers:

Some difficulties emerge in the implementation of ABC system, such as


selection of cost drivers, assignment of common costs, varying cost
driver rates etc.

3. Disadvantages to Smaller Firms:

ABC has different levels of utility for different organisation such as large
manufacturing firm can use it more usefully than the smaller firms.
Also, it is likely that firms depending on cost-plus pricing can take
advantages from ABC as it gives accurate product cost. But those firms
who use market based prices may not favour ABC. The level of
technology and manufacturing environment prevailing in different firms
also affect the application of ABC.

4. Measurement Difficulties:

The main costs and limitations of an ABC system are the measurements
necessary to implement it. ABC systems require management to
estimate costs of activity pools and to identify and measure cost drivers
to serve as cost allocation bases. Even basic ABC systems require many
calculations to determine costs of products and services. These
measurements are costly. Activity cost rates also need to be updated
regularly.

MCQs:
1. An approach in which company under-costs it's one product
and over-costs at least one product is classified as

a) service-cost across subsidizing


b) product-price cross subsidizing
c) product-cost cross subsidizing
d) product cross subsidizing

2. In an activity based cost system; an activity/unit of work or task


with differentiated purposes will be classified as

a) different task
b) purpose cost
c) an activity
d) an allocation cost

3. Costs of all activities for individual products or services can be


called

a) purpose level costs


b) output-unit level costs
c) input-unit level costs
d) activity level costs

4. In an activity based costing implementation, product's diverse


demand is based on

a) batch size
b) complexity
c) process steps
d) all of above

5. Broad's average use to assign cost of revenue to cost objects


will be classified as
a) refined costing system
b) refined selling system
c) undefined costing
d) defined selling system

6. Costs of all activities for a group of products, rather than


individual product can be classified as

a) activity level costs


b) input level costs
c) batch level costs
d) output level costs

7. Product which requires low amount of resources, but incur


high per unit cost is classified as

a) expected under cost


b) expected over cost
c) product under costing
d) product over costing

8. In activity based costing system, description of activity can be


classified as

a) activity list
b) activity dictionary
c) active purpose
d) both a and b

9. Factors that accelerate process of refining a costing system


include

a) increase in product diversity


b) increase in indirect costs
c) product market competitions
d) all of above

10. Cost pool category, which have similar cause and effect
relationship, with each cost driver uses as an allocation base is
classified as

a) heterogeneous price pool


b) homogenous cost pool
c) heterogeneous cost pool
d) homogenous price pool

11. In activity based costing method implementation, indirect


costs are allocated by using the

a) no cost pool
b) One or two cost pools
c) sustained tracing
d) support tracing

12. Costing system, in which individual activities are identified


as cost object, is considered as

a) manufactured costing
b) activity based costing
c) allocation costing
d) base costing

13. Type of costs that cannot be traced for individual products


but help in supporting an organization are classified as

a) individual sustaining costs


b) facility sustaining costs
c) sustained tracing
d) support tracing
14. In activity based costing method implementation, an output
unit level costs are classified as

a) indirect costs
b) direct cost
c) labor cost
d) raw material cost

15. Hierarchy which is based on different types of cost allocation


and drivers, to categorize cost pool activity is classified as

a) cost hierarchy
b) price hierarchy
c) activity hierarchy
d) purpose hierarchy

16. Product which requires large amount of resources, but incur


low per unit cost is classified as

a) product under costing


b) product over costing
c) expected under cost
d) expected over cost

17. Costs of undertaken activities is to support individual


products and are known as

a) expected sustaining
b) input sustaining
c) output sustaining
d) product sustaining costs

Answers:

1. c
2. c
3. b
4. d
5. a
6. c
7. d
8. d
9. d
10. b
11. b
12. b
13. b
14. a
15. a
16. a
17. d

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