Principles Of Activity-based costing(ABC)

Managers should be quite familiar with the two traditional costing systems namely absorption costing and marginal costing which are used to account or treat overhead costs.

However, neither system is able to provide satisfactory information about overheads costs for managers to use in runing a business. Earlier, we know that management accounting information is used by managers for helping them make decisions, for planning and control and for performance appraisal.

To circumvent the disadvantages from the aforesaid traditional costing systems, activity-based costing is the obvious new accounting way for accounting for overhead costs.

Let’s understand the salient points of activity-based costing:

1. Activity-based costing (ABC) unlike other traditional costing is based on the concept of assigning costs based on the activities that drive costs rather than the volume or number of units produced.

• It involves analyzing all activities to identify what drive costs, that is, what cause costs to be incurred. Examples of costs drivers includes like production set ups, packing, engineering, receiving in addition to machine or labour hours

• Therefore, ABC basically calculates the costs of individual activities and assigns costs to cost objects such as products and services on the basis of the activities undertaken to produce each product or service.

2 The existence of the following condition will be beneficial for the implementation of Activity-based costing system(ABC):

• When production overheads are high relative to total cost,
• When significant amount of overheads are allocated using only one or two cost pools,
• When there is a great diversity of product range where the products make diverse demands on resources because of differences in volume, process steps, batch size, or complexity,
• When there is considerable diversity of overhead resource input to the products,
• When consumption of overhead is not driven primarily by volume,
• Products that a company is well-suited to make and sell show small profits while products for which a company is less suited show large profits,
• Complex products appear to be very profitable and simple products appear to be losing money,
• Operations staff have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.

3. ABC systems commonly use a four-part cost hierarchy to identify cost-allocation bases.
A cost hierarchy is a categorization of costs into different cost pools on the basis of the different types of cost drivers (cost-allocation bases) or different degrees of difficulty in determining cause-and-effect relationships.

The four-part cost hierarchy to identify cost-allocation bases:

• Output Unit-Level Costs:resources sacrificed on activities performed on each individual unit of product or service. Example: Energy, Machine depreciation and Repairs

• Batch-Level Costs:resources sacrificed on activities that are related to a group of units of product(s) or service(s) rather than to each individual unit of product or service. Examples are: Setup hours, and Procurement costs

• Product-Sustaining:service-sustaining, costs are resources sacrificed on activities undertaken to support individual products or services. Examples are: Design costs and Engineering costs

• Facility-Sustaining Costs:are resources sacrificed on activities that cannot be traced to individual products or services but support the organization as a whole. Examples are: General administration and rent and building security

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