ACTIVITY BASED COSTING

INTRODUCTION ABC came to prominence in the 1980s, as companies strove to improve their products and services at the same time as pare down costs. They achieved impressive results, with the consequence that ABC is increasingly popular—particularly in manufacturing sectors. Activity-Based Costing (ABC) is a method for estimating the resources required to operate an organization's business processes, produce its products and serve its customers. It is a costing model that identifies the cost pools, or activity centres, in an organisation and assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or service. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives.

METHODOLOGY ABC as with other management accounting techniques has its own terminology. Terms such as 'Activity', 'Cost Driver', 'Cost Pool', and 'Cost Driver Rate' all have particular meanings. An Activity is defined as "a value adding process which consumes resources". A Cost Driver is "an activity or factor which generates cost" for example in our business a cost driver could be inspections in the quality control function. A Cost Pool is the "pooling of overhead cost which relates to a specific activity". For example the overheads associated with the inspection process in quality assurance would together form a 'cost pool'.

And finally a 'Cost Driver Rate' is the product of dividing the cost pool for the activity by the cost driver volume .this for example could be the cost of the 'quality' pool. DIFFERENCE BETWEEN ABC AND TRADITIONAL COST ACCOUNTING METHODS In the more sophisticated businesses in flexible and rapidly changing product ranges traditional techniques have proved to be in certain scenarios less than adequate. The application of ABC involves a set procedure: • • • • • accounting for and collection of overhead allocation of overhead to form cost pools associated with ‘value adding’ activities identification of cost drivers determination of cost driver rates ie: pool / driver volume recovery and charging of overhead to product / service based upon the demand for the activity. Activity Based Costing or ABC offers a workable and more effective insight into overhead allocation and recovery. The grey boxes indicate stages that not all pathfinders carried out and the numbers in circles indicate the number of pathfinders using this stage. The diagram below shows the broad steps in the ABC exercises carried out by pathfinders. divided by the number of inspections. So what is really the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance. there are three major differences: .

and the manpower required to paint the room. Traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels.1. This practice has allowed contractors to calculate a cost per area and manpower per area. equipment. The amount of hours associated with those costs were also collected. APPLICATION OF ACTIVITY BASED COSTING The results generated by Activity Based Costing methods are frequently used to produce reasonable standards on which future estimates can be calculated. In traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities. this data included the cost of the paint. Activity Based Costing methods are also used to evaluate specific activities within an organization to determine whether those activities are being conducted efficiently. As an example. and overhead to paint a room. whether other groups within your organization are performing those activities better than others. . the amount of surface area painted. whether those activities are necessary. 3. labor. whether certain materials or tools help your organization complete those activities more efficiently. Traditional cost accounting is structure-oriented whereas ABC is processoriented. 2. For example. for years construction firms and industry trade groups have collected cost data on a wide array of construction projects. and are known as ABC. These costs are based on an activity. such as painting. etc.

ABC has helped enterprises in answering the market need of better quality products at competitive prices. With ABC. Accurately predict costs. Easily identify the root causes of poor financial performance. . apportionment and absorption. recent research suggests that by improving the quality of cost and management accounting information. enterprises are able to improve their efficiency and reduce the cost without sacrificing the value for the customer. There’s also a danger that managers get so wrapped up in tracking costs that they take their eyes off the activity itself. Overall.however. Equip managers with cost intelligence to drive improvements.ADVANTAGES OF ACTIVITY BASED COSTING Activity Based Costing has the following typical benefits: • • • • • • • • • Identifying the most and least profitable customers. ABC involves so much data collection that it can take up a lot of time. Track costs of activities and work processes. Determine the true contributors to. profits and resource requirements associated with changes in production volumes. the ABC method has contributed effectively for the top management’s decision making process. any enterprise will have a built in competitive cost advantage and can continuously add value to both its stakeholders and customers. products and channels. With Activity Based Costing. Analyzing the product profitability and customer profitability.financial performance. This has also enabled enterprises to model the impact of cost reduction and subsequently confirm the savings achieved. Achieve better Positioning of products However. it also provides managers with a wider understanding of the economies of production and those resource consuming activities which when linked to the labour and capital provide the wealth we know as 'value added'. organizational structure and resource costs. Activity Based Costing (ABC) is a dynamic method for continuous improvement.and detractors from. Many companies also use ABC as a basis for a balanced scorecard. Facilitate better Marketing Mix Enhance the bargaining power with the customer. ABC generates improved or more accurate product costs . CONCLUSION Some researchers would argue that compared with traditional approach to overhead allocation.

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