Chapter 9: Costing Methods Flashcards
Activity based costing
ABC is a form of absorption costing where the overheads of a particular cost centre are split into groups of overheads that behave in a similar way.
These groups of overheads are known as cost pools.
Cost pools are absorbed into production units by identifying the activity that causes them to increase, this activity is known as the cost driver.
Traditional absorption costing formula
OAR = Overhead / activity
Advantages of ABC
Overhead absorption into units is based on their use of resources
Enables more accurate costing information to be generated
Easy to see where high levels of cost occur and their causes which will help to control them to improve profit.
Encourages improvements in processes by considering how the business can operate more efficiently.
Disadvantages of ABC
It is complex to set up and run which may be more difficult for staff to cope with.
More time consuming then traditional absorption costing and therefore costly.
May give too much detail and be confusing for users.
Appropriateness of ABC
It is more time consuming than traditional absorption costing. We only want to use it when it is appropriate. The following situations will be appropriate for using absorption costing:
-Overheads make up a large proportion of total costs
-The company makes more than one product, and products have different levels of activity associated with them
Challenges introducing ABC
Lack of understanding - ABC not fully understood by managers and therefore is not accepted as a means of cost control
Difficulty in identifying appropriate cost drivers - for example property costs are often significant and yet a single driver is difficult to find
Lack of appropriate accounting records - ABC needs a new set of accounting records, this is often not immediatley available. The setting up of new cost pools is time consuming.
Impact of ABC on selling prices and profitability
It may suggest that certain products are profitable which previously appeared not to be profitable.
As overheads become a more significant element of production costs, with more being automated rather than done by hand, it becomes increasingly important to identify the true cost drivers so that pricing decisions, inventory valuation and shutdown decisions can be made using more relevant information.
Switching from traditional absorption costing to ABC can result in a significant change in the cost per unit. An organisation may decide to:
-Charge more for some products and less for others
-Stop producing some products as they are no longer profitable at the current market price
