Activity Based Costing – Overhead, in traditional costing system, overhead costs are grouped together under cost center and then absorbed into product costs on either of the basis such as direct labour hours, machine hours, volume etc. In certain cases, this traditional costing system gives inaccurate cost information. Though, it should not be assumed that all traditional absorption costing systems are not accurate enough to give adequate information for pricing purposes or other long-run management decision purposes. Some traditional systems treat overheads in a detailed way and relate them to service cost centres as well as production cost centres. The service centre overheads are then spread over the production cost centres before absorption rates are calculated. The main cause of inaccuracy is in the calculation of the overhead rate itself, which is usually based on direct labour hours or machine hours. These rates assume that products that take longer to make, generate more overheads and so on.
Organisations, who do not wish to know how much it costs to make a product with precise accuracy, may be happy with traditional costing system. Others, however, fix their price on cost basis and need to determine it with reasonable accuracy. The latter organisations have been greatly benefitted from the development of activity based costing (ABC), which is considered as a modern absorption costing method, and was evolved to give more accurate product costs.
- Factors prompting the development of ABC
Various factors lead to the development of ABC include:
- Growing overhead costs because of increasingly automated production
- Increasing market competition, which necessitated more accurate product costs.
- Increasing product diversity to secure economies of scope & increased market share.
- Decreasing costs of information processing because of continual improvements and increasing application of information technology.
Usefulness/Suitability of ABC
ABC is particularly needed by organisations for product costing in the following situations:
- High amount of overhead: When production overheads are high and form significant costs, ABC is more useful than traditional costing system.
- Wide range of products: ABC is most suitable, when, there is diversity in the product range or there are multiple products.
- Presence of non-volume related activities: When non-volume related activities e.g. material handling, inspection set-up, are present significantly and traditional system cannot be applied, ABC is a superior and better option. ABC will identify non-value-adding activities in the production process that might be a suitable focus for attention or elimination.
- Stiff competition: When the organisation is facing stiff competition and there is an urgent requirement to compute cost accurately and to fix the selling price according to the market situation, ABC is very useful. ABC can also facilitate in reducing cost by identifying non-value-adding activities in the production process that might be a suitable focus for attention or elimination.
MEANING AND DEFINITION –Activity Based Costing
Activity Based Costing is an accounting methodology that assigns costs to activities rather than products or services. This enables resources & overhead costs to be more accurately assigned to products & services that consume them. ABC is a technique which involves identification of cost with each cost driving activity and making it as the basis for apportionment of costs over different cost objects/ jobs/ products/ customers or services.
ABC assigns cost to activities based on their use of resources. It then assigns cost to cost objects, such as products or customers, based on their use of activities. ABC can track the flow of activities in organization by creating a link between the activity (resource consumption) and the cost object.
CIMA defines ‘Activity Based Costing’ as “An approach to the costing and monitoring of activities which involves tracing resource consumption and costing final outputs. Resources are assigned to activities, and activities to cost objects based on consumption estimates. The latter utilise cost drivers to attach activity costs to outputs.”
MEANING OF TERMS USED IN ABC
- Activity – Activity, here, refers to an event that incurs cost.
- Cost Object–It is an item for which cost measurement is required e.g. a product or a customer.