In traditional costing, direct material, direct labor and direct expenses are identified with the jobs and all other expenses are accumulated under the head “overheads” and are charged to the jobs on the basis of one or two measurements such as direct labor cost or direct material cost of the jobs.
Proponents of activity based costing first brought out the fact that product costs derived by using traditional costing techniques are giving wrong information. The actual product cost of certain jobs is high but traditional costing system is reporting a low cost for them. If the selling price is determined on the basis of such wrong low cost, at the end of the year, companies find that they have not earned the anticipated profits.
In activity based costing, all the costs which are classified as overheads in traditional costing system are accumulated under various activities which are carried out in the organization. From the activity cost for a period, and the number of times the activity is carried out in the period, cost for doing the activity once is ascertained. Then an account is maintained each time the activity is carried and the job responsible for performing the activity is recorded. Therefore the activity cost can be charged to the job.
Thus the job cost, now comprises of direct material cost, direct labor costs, direct expenses and costs of each of the activities consumed by the job.
Activity based costing provides a more realistic estimate of costs of products.
Normally compared to traditional costing system, ABC system provides lower cost figures for standard products and higher cost figures for nonstandard orders.
The logic of ABC systems is that more finely structured activity-cost pools with activity-specific cost-allocation bases, which are cost drivers for the cost pool, lead to more accurate cost-allocation systems
Hierarchy of Cost Pools
ABC systems commonly use a four-part cost hierarchy or hierarchy of cost pools - output unit-level costs, batch-level costs, product-sustaining costs, and facility sustaining costs - to identify cost-allocation bases that are preferably cost drivers of costs in activity cost pools.
Implementing Activity-Based Costing
1. Identify the chosen cost objects
2. Identify the direct costs of the products
3. Select the cost-allocation bases to use for allocating indirect costs
4. Identify the indirect costs associated with each cost-allocation base
5. Compute the rate per unit of each cost-allocation base used to allocate indirect costs to the products
6. Compute the indirect costs allocated to the products
7. Compute the total costs of the products by adding all direct and indirect costs assigned to them.
Use of ABC Systems
Pricing and Product-mix decisions
Cost Reduction and Process Improvement Decisions
Design Decisions
Planning and Managing Activities
Based on
Horngren et al. Cost Accounting Chapter 5. Activity Based Costing and Activity-Based Management, 10th Edition
Cost Accounting - Horngren et al., Book Information and Review
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