Developing Activity-Based Costing (ABC) | Cost Accounting

The following points highlight the top ten factors for developing Activity-Based Costing (ABC).

1. Traditional product costing systems cannot report accurate product or service cost.

2. Traditional costing methods of overhead absorption use volume-related measures, such as direct labour hours, or machine hours etc. But there are many overhead expenses which are not related to physical volume.

These are related to support activities such as material handling, material procurement, setting-up of machines etc. These activities and their cost should not be allocated to products on the basis of production volumes.

3. Traditional product costing systems assume that products or services produced consume all resources in proportion to their production volumes. Thus products or services which take more time to manufacture, generate more overheads. This assumption leads to under-costing of low volume products or over-costing of high volume products or services.

4. Traditional costing system distorts products or service cost when the firm produces different products or services which make diverse demand on resources. Products or services make diverse demand on resources because of volume, process set-up, batch size or complexity.

5. This system fails to reflect the cause and effect relationship between activity consumption and cost incurrence.

6. Traditional cost accounting systems are driven by the need to value stock rather than to provide meaningful information for managing activities and controlling the causes of cost (i.e., cost driver).

7. Overhead expenses are not a mere burden to be maintained. Overhead costs for support functions, such as, product design, quality control, customer service, production planning and sales order processing are as important to the customer as physical process on the shop floor.

8. This system fails to highlight inter-relationship among the various activities of production departments.

9. Complexity in business has increased. Product ranges are wider. Product cycles are shorter and demand for quality product is higher.

10. Market place is more competitive necessitating correct product or service cost.

Illustration:

A company manufacturing two products, furnishes the following data for a year

Factors for Developing Activity-Based Costing (ABC) With Illustration 4

You are required to calculate the cost per unit of each product A and B based on:

Activity-based Costing Method:

Activity-Based Costing MethodOverhead Cost Per UnitOverhead Cost Per Unit

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