WHAT IS THE DEFINITION OF ACTIVITY BASED COSTING

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Activity based costing (ABC) involves the identification of the factors which cause the costs of an organisation's major activities. Support overheads are charged to products on the basis of their usage of the factor causing the overheads (Drury, C.2008). Allen, M.W&Myddelton, D.r (1992) states "Activity based costing system (ABC) relates overhead costs to products via cost drivers". In addition, the activity based costing system is globally recognised as a important tool for developing the behavioural, business and accounting practices in companies (Anderson,1995;Cooper and ZmUD,1990;Foster and Swenson,1997;Mcgowan and Klammer,1997;Shields,1995) cited by Maiga,S.A&Jacobs,A.F(2003).

DETAILS OF THE DEVELOPMENT OF THE TECHNIQUE AND THE UNDERLYING CONCEPT:

During the 1980s the ABC method was designed in the USA because of traditional systems unable to determine accurately production and service costs or to provide fully useful information to support operational decision making (Cooper and Kaplan, 1988). ABC favours better cost allocation using smaller cost pools called activities. Using cost drivers, the costs of these activities are the basis for assigning costs to other cost objects such as products or service Activity -based costing (ABC) was developed to address the deficiencies of traditional costing system in the modern business environment. It helps manager understand the product and customer profitability and identify major areas for process improvement (Kirche, E & Srivastava, R. 2005). Many companies have found that by implementing ABC costing system best performance can be achieved (Compton, 1996).The basic principle of this costing is that cost units should bear the costs of an organisation's major activities which they cause and all costs are driven by activities which take place in the business environment. (Gowthorepe, C .2003).

Traditional costing versus activity based costing:

Atrill, P &Mclaney, E.p.294 (2008) states that the traditional costing versus ABC costing.

Traditional approach:

Overheads are first assigned overheads are then allocated to cost units

To product cost centres using an overhead recovery rate

Total

Overheads

Products

A B C D

Cost centre overhead

Recovery rate 1

Product cost

Centre 1

Product cost

Centre 2

Cost centre overhead

Recovery rate 2

Cost centre overhead

Recovery rate 3

Product cost

Centre 3

ABC APPROACH:

Overheads are first assigned overheads are then allocated to cost units

To product cost pools using cost driver rates

Products

A B C D

Total

Overheads

Activity cost driver rate 1

Activity cost pool

1

Activity cost driver rate 2

Activity cost pool

2

Activity cost driver rate 3

Activity cost pool

3

Activity cost pool

4

Activity cost driver rate 4

In traditional approach, overhead are first assigned to product cost centres and then overhead are absorbed by cost units based on the overhead recovery rate for each department. On the other hand in activity based costing system overhead is assigned to cost pools and then cost units are charged with overheads to the extent that they drive the costs in to various pools.

Cost pool: A cost pool is like a cost centre in traditional absorption costing. The costs of an activity are collected into cost pools(Atrill, P &Mclaney, E.2008).

Cost driver: A cost driver is the factor which the costs of an activity(Atrill, P &Mclaney, E.2008).

An ABC system operates as follows:

STEP 1: Identify main activities of an organization.

STEP 2: Collect the costs of each activity into cost pools.

STEP 3: Identify the cost driver for each main activity/cause.

STEP 4: Charge support overheads to products on the basis of their usage of the activity.

(Drury, C.2008)

EXAMPLE: ABC

Suppose that Cooplan LTD manufactures four products,W,X,YAND Z. Output and cost data for the period just ended are as follows:

Output number of material cost direct labour machine

Units production per unit per unit hours per

runs in the unit

Period £

W 10 2 20 1 1

X 10 2 80 3 3

Y 100 5 20 1 1

Z 100 5 80 3 3

Direct labour cost per hour is £5. Overhead costs are as follows.

Short run variable costs ………………… £3080

Set up costs………………………… £10920

Production and scheduling costs…… £9100

Material handling costs……………… £7700

Calculate the product cost using the ABC approaches.

Using activity based costing and assuming that the number of production runs is the cost driver for set up costs, production and scheduling costs and materials handling costs that machine hours are the cost driver for short run variable costs, unit costs would be as follows.

W X Y Z TOTAL

£ £ £ £ £

Direct material 200 800 2000 8000 11000

Direct labour 50 150 500 1500 2200

Short run variable overheads (w1) 70 210 700 2100 3080

Set up costs (w2) 1560 1560 3900 3900 10920

Production and scheduling costs (w3) 1300 1300 3250 3250 9100

Material handling costs (w4) 1100 1100 2750 2750 7,700

4280 5120 13100 21500 44000

Unit produced 10 10 100 100

Cost per unit £428 £512 £131 £215

Workings:

1. £3080/440 machine hours = £7 per machine hour

2. £10920/14 production runs = £780 per run

3. £9100/14 production runs = £650 per run

4. £7700/14 production runs = £550 per run

(BPP,F5,2008)

ADVANTAGES

Here some advantages of ABC:

Because of financial reporting requirement we have to value inventories at full cost, where absorption costing has not given meaningful product costs to produce the full cost. On the other hand, ABC focuses attention on the nature of the costs behaviour and tries to provide accurate product costs. (BPP, F5, 2009).

Multiple cost drivers are used in ABC to allocate indirect costs to activities and then to products.ABC can identifies that many indirect costs arise out of the diversity and complexity of operations.( BPP, F5, 2009).

ABC recognises wider product rages, shorter product life cycles, and more complex production process with its multiple cost drivers.( BPP, F5, 2009).

In manufacturing organisations indirect costs functions include a lot of non - factory activities for example product design , quality control and customer services and in this sector ABC is concerned with all overhead costs. (BPP, F5, 2009).

ABC helps with future product planning e.g. the cost of all activities associated with a product or service can be accurately determined before it is launched. That is why business can determine about the price and any other expenditure easily. (managers - net)

The application of ABC results in significant improvement in the quality of information which obtained from costing system and better control and planning. (Gowthorepe, C .2003)

WEAKNESS OF ABC :

Critics think that activity costing system has some weakness:

The work of Wegmann, G .(2009) emphasised that ,many scholars and practitioners admit that ABC has several pitfalls. We can list the major criticisms as follows:

A lot of practitioners argue that ABC systems are expensive to implement, time consuming and hard to adjust.

Especially in the service industries a lot of failures have been complained.

In addition, some people think that this method (ABC) is too complex.

Analysing overheads in order to identify cost drivers is time consuming and costly (Atrill, P &Mclaney, E.2008).

ABC does not provide relevant information for decision making (Atrill, P &Mclaney, and E.2008).

Gowthorepe, C (2003) emphasises that ABC is more complex system a lot of information has to be collected and administered and implement cost is high.

ABC is a fashionable costing, not because it will be used by management to provide meaningful product costs or extra information. Management may be use traditional absorption costing system than ABC information (BPP, F5, 2009).

BPP,F5,P.42(2009) states:'To have useable cost driver, a cost must be caused by an activity that is measureable in quantitative terms and which can be related to production output. But not all costs can be treated in this way. For example, what drives the cost of the annual external audit?'

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