Definition of Activity Based Costing (Kaplan).

Activity based costing is a costing method that has been developed to deal with the perceived weaknesses of traditional absorption costing.
Traditional absorption costing is based on the principal that production overheads are driven by the level of production. This is reflected in the choice of activity level in the overhead absorption rate (OAR) calculation - typically units, labor hours or machine hours. These all increase as the level of production increases.This was true in the past, because businesses only produced one simple product or a few simple and similar products.



Advantages and disadvantages of ABC:-

Advantages
:

1. ABC provides a more accurate cost per unit. As a result, pricing, sales strategy, performance management and decision making should be improved.

2. It provides much better insight into what drives overhead costs.

3. ABC recognizes that overhead costs are not all related to production and sales volume.

4.In many businesses, overhead costs are a significant proportion of total costs, and management needs to understand the drivers of overhead costs in order to manage the business properly. Overhead costs can be controlled by managing cost drivers.

5.It can be applied to derive realistic costs in a complex business environment.

6. ABC can be applied to all overhead costs, not just production overheads.

7. ABC can be used just as easily in service costing as in product costing.


Disadvantages of ABC:

1. ABC will be of limited benefit if the overhead costs are primarily volume related or if the overhead is a small proportion of the overall cost.

2. It is impossible to allocate all overhead costs to specific activities.

3.The choice of both activities and cost drivers might be inappropriate.

4.ABC can be more complex to explain to the stakeholders of the costing exercise.

5. The benefits obtained from ABC might not justify the costs.

6. Other systems may need to be changed - for example, how variances are calculated.

Activity based costing is helpful in determining the unused capacity in the system. It also accounts separately for the complex processes since more resources are allocated in those processes. It is usually used in complex layouts unlike in a simple plant or a department. It helps in matching the costing with the hours consumed .


Calculating the full production cost per unit using ABC:-

Step 1: Group production overheads into activities, according to how they are driven.

A cost pool is an activity which consumes resources and for which overhead costs are identified and allocated.

For each cost pool, there should be a cost driver. The terms 'activity' and 'cost pool' are often used interchangeably.

For example, one activity could be "quality control"


Step 2: Identify cost drivers for each activity, i.e. what causes these activity costs to be incurred.

A cost driver is a factor that influences (or drives) the level of cost.

For example, we could argue that the cost of quality control is driven by the number of inspections made, rather than the total number of units produced


Step 3: Calculate an OAR for each activity.

The overhead absorption rate (OAR) is calculated in the same way as the absorption costing OAR. However, a separate OAR will be calculated for each activity, by taking the activity cost and dividing by the cost driver information.

For example, we could determine a cost per inspection for quality control costs.


Step 4: Absorb the activity costs into the product.

The activity costs should be absorbed back into the individual products.

For example, if we know how many inspections were made on product X then we can absorb a corresponding quantity of quality control costs.


Step 5: Calculate the full production cost per unit and/ or the profit or loss.

Total activity costs can them be added to labor and material costs as normal.
 
Activity based costing is a costing method that has been developed to deal with the perceived weaknesses of traditional absorption costing.
Traditional absorption costing is based on the principal that production overheads are driven by the level of production. This is reflected in the choice of activity level in the overhead absorption rate (OAR) calculation - typically units, labor hours or machine hours. These all increase as the level of production increases.This was true in the past, because businesses only produced one simple product or a few simple and similar products.



Advantages and disadvantages of ABC:-

Advantages
:

1. ABC provides a more accurate cost per unit. As a result, pricing, sales strategy, performance management and decision making should be improved.

2. It provides much better insight into what drives overhead costs.

3. ABC recognizes that overhead costs are not all related to production and sales volume.

4.In many businesses, overhead costs are a significant proportion of total costs, and management needs to understand the drivers of overhead costs in order to manage the business properly. Overhead costs can be controlled by managing cost drivers.

5.It can be applied to derive realistic costs in a complex business environment.

6. ABC can be applied to all overhead costs, not just production overheads.

7. ABC can be used just as easily in service costing as in product costing.


Disadvantages of ABC:

1. ABC will be of limited benefit if the overhead costs are primarily volume related or if the overhead is a small proportion of the overall cost.

2. It is impossible to allocate all overhead costs to specific activities.

3.The choice of both activities and cost drivers might be inappropriate.

4.ABC can be more complex to explain to the stakeholders of the costing exercise.

5. The benefits obtained from ABC might not justify the costs.

6. Other systems may need to be changed - for example, how variances are calculated.

Activity based costing is helpful in determining the unused capacity in the system. It also accounts separately for the complex processes since more resources are allocated in those processes. It is usually used in complex layouts unlike in a simple plant or a department. It helps in matching the costing with the hours consumed .


Calculating the full production cost per unit using ABC:-

Step 1: Group production overheads into activities, according to how they are driven.

A cost pool is an activity which consumes resources and for which overhead costs are identified and allocated.

For each cost pool, there should be a cost driver. The terms 'activity' and 'cost pool' are often used interchangeably.

For example, one activity could be "quality control"


Step 2: Identify cost drivers for each activity, i.e. what causes these activity costs to be incurred.

A cost driver is a factor that influences (or drives) the level of cost.

For example, we could argue that the cost of quality control is driven by the number of inspections made, rather than the total number of units produced


Step 3: Calculate an OAR for each activity.

The overhead absorption rate (OAR) is calculated in the same way as the absorption costing OAR. However, a separate OAR will be calculated for each activity, by taking the activity cost and dividing by the cost driver information.

For example, we could determine a cost per inspection for quality control costs.


Step 4: Absorb the activity costs into the product.

The activity costs should be absorbed back into the individual products.

For example, if we know how many inspections were made on product X then we can absorb a corresponding quantity of quality control costs.


Step 5: Calculate the full production cost per unit and/ or the profit or loss.

Total activity costs can them be added to labor and material costs as normal.
Hey friend, thanks for the information. Well, as we know that activity-based costing is a costing technique that recognizes activities in a company and designates the cost of each activity with assets to all products and services based on the actual consumption by each. For more detailed information, please download my presentation.
 

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