ALTERNATIVE COSTING PRINCIPLES

ACTIVITY BASED COSTING: ABC is replacement of absorption costing where each activity has it’s own
cost driver. Like for quality control , number of inspections is a relevant cost driver, for procurement we
will use purchase orders . For sales and distribution we will use number of sales orders. Under
absorption costing there is only one cost driver which deals with all production overheads like mach.
Hours, lab. Hours, production units. Under absorption costing we use Overhead absorption rate for all
products.

OAR/Mach. Hour = Budgeted fixed pro. oh’s/ Budgeted activity level

OAR/Mach hour = $700,000/70000 = $10/hr
Product A : 25000 hours *$10 = $250,000
ABC Example:
Procurement $200000 Purchase order 400
Quality control $150000 No. of inspections 800
Machine dept. $200000 Machine hours 70000
Sales & distribution $150000 No. of sales orders 1000
700,000
Steps:
Step 1 : Cost/ driver = Total oh’s / Total cost drivers
Cost/ Purchase order = $200000/400 = $ 500/ P.O
Cost/ inspection = $150000/800 = $ 187.5/inspection
Cost/mach. Hour = $ 200,000/70000 = $ 2.857/hr
Cost/sales order = $ 150000/1000 = $ 150
Step 2 : Total oh’s of A product: No. of cost drivers consumed *Cost/driver
Product A :
Procurement: 70*$500 = $ 35000
Quality control : 150*$187.5 = $28,125
Machining : 25000*$2.857 = $ 71,425
Sales & distribution : 150*$150 = $22500
157,050
Step 3 : Cost/unit = Total oh’s of a product/Total production units
Product A Cost/unit = $ 157,050/ 10000 units = $15.7050

ABC is more reliable method than absorption costing for product profitability analysis because it uses
Different cost drivers for each product and it helps to decide which one of the products are contributing
Higher profit and which are not. Company can use this method to decide either to continue a product or
not . ABC is more useful where there are number of activities are performed and there are number of
cost drivers exists so we can say ABC is more useful in complex business environment.

ABC is more time consuming method which means it is costly. This method is not useful for all the
organisations because a few companies cannot afford ABC. At times companies does not have variety of
cost drivers so they use one cost driver for more than one activities.