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Understanding Activity-Based Costing

Activity-based costing (ABC) assigns costs to products and services based on their actual consumption of resources. It assigns more indirect costs directly to products and services, allowing companies to understand the true costs of individual offerings. ABC was developed in the 1970s-1980s to address limitations of traditional costing systems, which often inaccurately determine production and service costs. While ABC better traces costs, some overhead remains difficult to assign and is considered "business sustaining" rather than allocated to specific products or customers.

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Taniya Sethi
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13 views6 pages

Understanding Activity-Based Costing

Activity-based costing (ABC) assigns costs to products and services based on their actual consumption of resources. It assigns more indirect costs directly to products and services, allowing companies to understand the true costs of individual offerings. ABC was developed in the 1970s-1980s to address limitations of traditional costing systems, which often inaccurately determine production and service costs. While ABC better traces costs, some overhead remains difficult to assign and is considered "business sustaining" rather than allocated to specific products or customers.

Uploaded by

Taniya Sethi
Copyright
© Attribution Non-Commercial (BY-NC)
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as DOC, PDF, TXT or read online on Scribd

ACTIVITY BASED COSTING Activity-Based Costing (ABC) is a costing model that identifies activities in an organization and assigns the

cost of each activity resource to all products and services according to the actual consumption by each, it assigns more indirect costs (overhead) into direct costs. In this way an organization can establish the true cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced. Historical Development Traditionally, indirect costs are distributed to end products on the assumption that products consume resources in proportion to the production volumes. Distribution of overhead cost was into Direct Costs and indirect Costs.

But now a days overhead have assumed greater importance and there is a need for a more sophisticated system for accounting of overhead. The concepts of ABC were developed in the manufacturing sector of the United States during the 1970s and 1980s. Robin Cooper and Robert S. Kaplan, proponent of the Balanced Scorecard, brought notice to these concepts in the beginning of 1988. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management systems. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Consequently managers were making decisions based on inaccurate data especially where there are multiple products.

Terms used in ABC


*Activity *Cost Object *Cost driver *Resource cost driver *Activity Cost Driver

Difference between Conventional Costing and Activity Based Costing

Conventi
Steps in Activity Based Costing

Identification of the main activities

Creation of Cost Pool

Determination of the activity cost drivers

Calculation of the activity cost driver rate

Charging the costs of activities to products

Advantages of Activity Based Costing


It helps to identify inefficient product, department and activity It helps to allocate more resources on profitable product, department and activity It helps to control the cost at individual level and on departmental level It helps to find unnecessary costs

ABC: Where to Use?


High Overheads Product Diversity or Multiple Products Customer Diversity Service Diversity Stiff Competition

Limitations
Even in activity-based costing, some overhead costs are difficult to assign to products and customers, for example the chief executive's salary. These costs are termed 'business sustaining' and are not assigned to products and customers because there is no meaningful method. This lump of unallocated overhead costs must nevertheless be met by contributions from each of the products, but it is not as large as the overhead costs before ABC is employed.

Although some may argue that costs untraceable to activities should be "arbitrarily allocated" to products, it is important to realize that the only purpose of ABC is to provide information to management. Therefore, there is no reason to assign any cost in an arbitrary manner

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