INSTITUTE OF ACCOUNTANCY ARUSHA
ACTIVITY-BASED COSTING (ABC) Introduction
Traditionally (conventionally) overheads are absorbed to cost objectives basing on the labour hours or machine hours.
Absorbed overheads = Actual hours * OAR
Where
Actual overheads may be actual labour hours or actual machine hours.
OAR=Overhead Absorption Rate=Overheads Application Rate=Overheads Recovery Rate
OAR = Budgeted Overheads Budgeted hours
ABC attempts to show the relationship between overhead costs and activities that cause them. It is a method of charging overheads to cost objectives on the basis of benefits received from the particular indirect activity e.g. ordering, planning, setting e.t.c.
Steps in Developing ABC System
Step 1: Identify the main activities in the organization.
Examples: Material handling, purchasing, reception, dispatch, machining, assembly e.t.c.
Step 2: Identify factors, which determine the costs of an activity.
These are known as cost drivers. Examples: number of purchase orders delivered, number of set-ups e.t.c.
Step 3: Collect the costs of each activity.
These are known as cost pools and are equivalent to conventional cost centres.
Step 4: Charge support overheads to products on the basis of their usage of the activity, expressed in terms of the chosen cost driver (s).
Example:
Purchase cost 200,000/=
Purchase orders (cost driver) 1,000 purchase orders
Cost per purchase order = 200,000 1,000
=200 per purchase order
Cost Assignment using Traditional Product Costing System
Direct Costs Indirect costs (or overheads)
Production Departments
Volume-Based OARs
Absorption on Labour or Machine hours
Products
Cost Assignment using Activity-Based Costing (ABC)
Direct Costs Indirect costs (or overheads)
Activity Cost Pools
Activity Cost Driver Rates
Costs Traced on Cost Driver Usage
Products
Under both methods direct costs in respect to products (as our cost objectives) are directly traced to specific products.
ABC cost driver rates should produce more realistic product costs, especially where support overheads are
IAA Ltd produces four products namely A, B, C and D. data for the past period are as follows:
Products A B C D TOTAL
(a) Using conventional product costing using labour hour or machine hour overhead absorption rate.
OAR = 27,180 = 16.47
** Total costs for all products should be under both methods equal. The slight difference is due to rounding off of the OAR in the conventional costing method.
It can be observed that ABC charges more overheads to lower volume production and tends to charge relatively less to higher volume production.
Advantages of ABC
(i) More realistic product costs are provided when support overheads are a significant proportion of
total costs.
(iii) ABC recognizes that it is activities, which cause cost, not products and it is products, which consume activities.
(iv) ABC focuses attention on the real nature of cost behaviour and helps in reducing costs and
identifying activities, which do not add value to the product.
(v) ABC recognizes the complexity and diversity of modern production by the use of multiple cost
drivers, many of which are transaction based rather than based solely on production volume.
(vi) ABC provides a reliable indication of long-run variable product cost which is relevant to strategic
decision-making.
(vii) ABC is flexible enough to trace costs to processes, customers, areas of managerial responsibility,
as well as product costs.
(viii) ABC provides useful financial measures ( e.g. cost driver rates) and non-financial measures (e.g.
transaction volumes).
(ix) The principle of using activities to trace costs can be applied across a range of service industries as
well as manufacturing firms.
Criticisms of ABC
(i) A full ABC system with numerous cost pools with multiple cost drivers is more complex than
traditional systems and will thus be more expensive to administer.
(ii) The applicability of ABC to companies which use the market-based pricing is questioned.
(iii) ABC does not solve many practical problems. Examples include common costs, cost driver selection, non-linearity of cost driver rates e.t.c.
Example
The following budgeted information relates to Bege Company Ltd for the forthcoming period:
Products
Overheads allocated and apportioned to production departments (including service cost centre costs) were to be absorbed in product costs as follows:
Machine department at 1.20 TShs per machine hour. Assembly department at 0.825 TShs per direct labour hour.
You ascertain that the above overheads could be reanalyzed into cost pools as follows:
You have also been provided with the following estimates for the period:
