Activity based costing is a departure from the traditional costing methods. ABC is a costing method developed to solve the problems presented by the traditional techniques. It allocates overheads to products based on the activities that are involved in the production.
Traditional costing methods resulted in accurate cost measurements thereby leading to wrong management decisions. ABC overcomes this by allocating the overheads to activities.
How it works
ABC starts by establishing the cost pools or activity centers. Overheads are then allocated to these cost pools. The cost pools can be materials ordering, machine set up, engineering etc.
The identification of the activities that are undertaken during the production process is done. These activities are called cost drivers. Examples of cost drivers are number of deliveries, number of production orders, number of machine set ups etc.
The next step is the allocation of the overheads in the cost pools to the cost drivers to arrive at the rate per cost drivers. Lastly the rate per cost driver is then divided by the number of units produced to get the cost unit. The total product cost per unit is arrived at by adding all the cost units (O Guin Pg.32)
Activity Based Costing helps the employees to establish and know the costs involved in the production process. This understanding helps them analyze and identify the cost drivers that add no value to the production process. This process then helps in the implementation of the continuous process with the aim of achieving cost efficiency better characterized by Kaizen Costing.
Advantages of ABC
ABC has the ability to correctly determine the costs, profits and the amount of resources needed in the production process and therefore it helps the management in their quest to improve the shareholders wealth.
The other apparent benefit of ABC is its ability to identify and pinpoint the profitability of the various products of the company. This therefore helps the company’s management to establish the reasons for any poor performance and thereby make appropriate decisions based on the available information.
The allocation of costs to cost drivers helps the management and the production team to follow the costs while the productionprocess is still on going. The advantage of this is that it enables these costs to be managed and controlled by adjusting the activities that generate these costs.
Page 2 Activity based costing Essay
Activity Based Costing provides the management with information on the products that generate most and least profits. Decision making is then made easierby the availability of this information.
In order to achieve competitive advantage, the management should be able to position the company’s products in a better way. ABC helps to achieve this and thus the company will understand the competitors, products, perception of the customers’ etc.
Effective cost reduction strategies can be formulated and adopted by the management only if they have accurate cost information and knowledge. This knowledge can be obtained using ABC.
The most obvious drawback of ABC is that of implementation. It is time consuming to identify cost drivers, allocate costs etc. Small companies with few activities can easily implement ABC but for large companies it is difficult because of the numerous activities. This difficulty can however be eliminated by use of ABC software. (Rockford Consulting Group Ltd 1999)
Where it can be used
It can be appropriately used by companies with many products but are bogged down by lack of accurate information on their production costs. (Rockford Consulting Group Ltd 1999).
The difficulties associated with ABC have led to the development of Time-driven ABC by Robert Kaplan and Steven Anderson.
In Time-Driven ABC, the requirements of all the processes involved in the production process i.e. transactions, products, buyers are determined. The essence of this is that it avoids the expensive continuous enhancement process undertaken by the employees in the traditional ABC.
Time-Driven ABC works as follows
The costs per time unit of capacity are calculated. This is the amount that is required to avail the resources to the activities that make up the cost.
Unit times of activities are also determined i.e. the amount of time to perform each activity with idle and unused times also being noted. Time-Driven ABC utilizes the time equations which enables the inclusion of real world complications e.g. specific order, customer and activity and their effects on time.
O Guin, Michael. The Complete Guide to Activity Based Costing. CCH Tax and
Value Based Management.net. Analyzing product and customer profitability 🙁 Time-Driven)
Activity Based Costing. 6/1/2008. Value Based Management. 29/1/2008.
RCG University. Activity Based Costing. 1999. Rockford Consulting Group, Ltd.29/1/2008.
12 Manage Management Communities. Activity Based Costing.12/1/2008. 12 Manage.
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