Activity Based Costing

Last Updated: 26 Jan 2021
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Probably the most popular proposal to upgrade the traditional cost accounting system is activity-based costing (ABC). The purpose of ABC systems is to focus on the causes behind indirect costs. It is primarily a system of allocation. Activities rather than traditional departments are emphasized in order to isolate the cost drivers, which are the factors most likely to cause or contribute to the incurrence of costs. ABC systems are designed to be complementary with the technological changes in the factories due to enhanced global competition. t refers to the basis for cost accumulation, either direct or indirect, to products or services.

The traditional approach to assigning costs to products is to attach those costs that are directly traceable to the product and allocate the indirect costs by a measure of volume, such as direct labor hours, direct labor dollars, or machine hours. According to Anderson and Kaplan (2004), a cardinal principle of ABC is this: if products or services are made to specifications known to add value for the customer, then activities, and hence costs, that can be removed without compromising these specifications are unnecessary and should be removed. Benefits of ABC Systems to Companies

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Companies can benefit from ABC through the system’s attempt to improve the allocation of indirect costs by identifying the activities that are responsible for the costs. Costs and expenses that cannot be economically traced directly to a cost objective are to be allocated on a rational basis. Costs and expenses that can be directly traced to a revenue-producing division, a single product line, or to any defined cost objective need not be allocated. Traditionally, only direct materials and direct labor were assumed to be directly traceable to separate product lines.

That assumption will no longer be followed. Instead, it will be assumed that elements of manufacturing overhead, administrative expenses, and marketing expenses may be economically traced to product lines, or revenue-producing divisions. ABC as a process-based approach represents one capital budgeting strategy for analyzing investment opportunities which allows managers to vary the underlying activity drivers in business processes in order to study the impact of different levels in the process itself.

Managers have the potential to learn much more about investment risks when they study the uncertainties in the business processes, rather than the traditional overview approach. This traditional approach has typically focused upon highly aggregated revenue and cost items that are merely the result of business processes. Contemporary organizations normally develop activity-based costing systems to provide more accuracy in assigning indirect and support costs to activities, business processes, products, services, and customers.

ABC systems have recognized that organizational resources are needed both for direct production of goods and services and for indirect or support activities (Neely, 2002). The goal of organizations is for the ABC to measure and then price out all the resources used for activities that generate the production off and services for customers. The principal difference between the traditional costing methods and ABC systems is the number and type of cost drivers used.

The traditional product costing systems uses allocation bases that may or may not have been cost drivers. Companies may find that direct labor is not a cost driver and may never be a cost driver, especially in highly automated production environments. Therefore, these companies utilize the ABC system because it uses a much larger number and variety of cost drivers than the one or two volume-based cost drivers typical for a traditional cost system. As a result the ABC method increases accuracy. Application and Benefits of ABC in the Pilgrims Manufacturing Inc.

Company Activity-based costing system is effective and appropriate for the company because, as Hammer and Champy (1993) state, it facilitates the use of process-based management that represents an evolving management strategy for highly competitive environments, as opposed to the traditional, departmental management focus. Moreover, activity-based costing focuses upon the broader control p of cross-functional processes of how work really gets done in organizations, as opposed to the narrow control p of individual departments of organizations.

Business processes have been discussed as a series of activities that are cross-functionally linked to achieve specific organizational objectives. An activity-based costing system should be developed within the company to satisfy some of the weaknesses of the traditional systems of accounting for and controlling costs. It is important to recognize the place of ABC systems in the overall picture of cost management. In traditional cost systems, direct materials and labor are the only costs traced directly to the product.

Manufacturing overhead costs, by definition, are not traced, but allocated to the product. They may be traced to an activity or a service department or some other cost objective, but not to the product itself. Administrative, engineering and marketing expenses are not included in production costs even when they can be traced directly to the product. ABC along with other new concepts such as computer-integrated manufacturing and total cost management advocate changes in the traditional system to coincide with technological changes in the production process.

Once the factory has been reorganized to provide maximum efficiency and minimum wasted resources, the cost system can be streamlined to serve the needs of managers, not just to satisfy the presentation of data in the financial statements. ABC seeks to identify activities that cause or drive costs. Once these activities are identified, product costs are assigned according to the activities consumed. Typical activities would be storage time, wait time, number of setups, number of engineering changes, and move time.

The traditional cost system usually assumes that the only relevant activities are volume (measured in units of product), direct labor hours, or direct labor dollars. ABC expands these activities and claims better assignment of overhead as a result. WORKS CITED 1. Anderson, S. & Kaplan, R. (2004). Time-Driven Activity-Based Costing. Harvard Business Review, November, pp. 131-138. 2. Hammer, M. & Champy, J. (1993). Reengineering the Corporation. New York, NY: Harper Business. 3. Neely, A. (2002). Business Performance Measurement: Theory and Practice. Cambridge University Press.

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Activity Based Costing. (2016, Aug 11). Retrieved from

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