Activity Based Costing Flashcards
What is ABC?
Activity Based Costing is an alternative approach to product costing
It is a form of absorption costing
It allocates overheads to cost pools before absorbing them into units using cost drivers
Grew out of dissatisfaction with traditional absorption costing
Why does ABC have dissatisfaction with the “traditional” method?
Output processes now more complex
Wider range of products/services
Direct costs (especially labour) now less significant
Traditional absorption rates based on output volume, but many overheads unrelated to volume
What are the basic principals of ABC?
ABC attempts to reflect consumption of resources rather than their acquisition or the volume of output
Basic principle:
activities incur costs
products/services consume activities
What is the process of ABC?
Identify major organisational activities
For each major activity identify cost driver
Allocate/apportion overheads to cost pool
for each activity
Develop absorption rate for each cost pool based on relevant cost driver
Compute overhead per unit
What should the identification of major activities be guided by in ABC?
Significance in terms of cost incurred
Importance to output processes
Ability to identify single related cost driver
Cost/benefit criterion
What are classification activities in ABC?
Unit level activities – occur every time a cost unit is produced
Batch level activities – occur every time a batch of units is produced
Product-sustaining activities – undertaken to allow particular products/services to be produced/sold
Facility-sustaining activities – undertaken so that the organisation as a whole can function
What are cost drivers?
A cost driver is the main underlying cause of an overhead
Cost drivers should: be readily measurable link activity, overhead and output be reasonable approximations of cause of activity’s cost be subject to cost/benefit criterion
What are OH cost pools?
An overhead cost pool is created for each activity
Equivalent of traditional method’s cost centre
Overheads are allocated and apportioned to cost pools
Secondary distribution not necessary
What is the absorption rate?
A cost driver absorption rate is developed for each activity
Like traditional rates predetermined may be preferable
ABC likely to have more absorption rates than traditional method
How do you calculate the absorption rate?
Total cost from cost pool / units of cost driver
What are the favourable conditions for ABC?
Production overheads are high relative to direct costs
Diversity in the product range
Diversity of overhead resource input to products
Consumption of overhead resources is not driven primarily by volume
What are the benefits of ABC?
More accurate product line costs
More flexible the approach can analyse costs by processes, areas of managerial responsibility and customers
ABC avoids the problem of cost absorption on an inappropriate basis
Provides a reliable indication of long-run variable product cost
Provides meaningful financial (periodic cost driver rates) and non-financial (periodic cost driver volumes) measures
Improves cost estimation by accurate identification and understanding of cost behaviour
What are the limitations of ABC?
Little evidence to date that ABC improves corporate profitability
ABC information is historic and internally orientated and therefore lacks direct relevance for future strategic decisions
Practical problems such as cost driver selection
It can be viewed as simply a rigorous application of conventional costing procedures
More expensive than traditional absorption costing as it requires more detailed information and analysis
