Module 11 Activity-Based Costing

Question 1

Main Principles of ABC

Answer 1

• Activities cause costs. Activities include ordering, materials handling, machining, assembly, production scheduling, despatching, marketing and selling
• Producing products creates demand for the activities
• Costs are assigned to a product based on the product’s consumption of the activities rather than one overhead absorption rate

Question 2

Outline of an ABC System

Answer 2

1. Identify an organisation’s major activities
2. Identify the factors which determine the size of the costs of an activity/ cause the costs of an activity.
3. Calculate total activity levels (e.g. total number of customer orders).
4. Collect the total overhead costs associated with each cost driver and work out the cost per cost driver (e.g. the cost per customer order).
5. Charge costs to products based on their usage of the activity (e.g., a product with lots of customer orders should have a higher proportion of the packing cost than a product with hardly any customer orders).

Question 3

6 Advantages of ABC

Answer 3

• Can provide more meaningful product costs than other costing methods
• Can provide more accurate information for decision making
• Can provide information on product or customer profitability
• Results in better pricing decisions
• Can allow companies to look at variances
• Overheads are charged to products on a more equitable basis, taking into account the products, consumption of cost drivers

Question 4

5 Disadvantages of ABC

Answer 4

• It should not be used to make decisions without an understanding of the cost behaviour of the costs involved. As ABC deals in apportionment of overheads, those overheads may be fixed and may be unavoidable if the product is discontinued
• In a single product or similar product situations it is of little benefit in determining product costs, although it may still be used to calculate costing for different customers of a one-product firm
• The (significant) cost of an ABC exercise may outweigh the benefits of the information provided by it
• Changing the technique of calculating costs does not alter the total actual costs
• In practice, some overheads simply cannot be traced to products.

Question 5

4 Favourable conditions for ABC

Answer 5

• When fixed production overheads are high relative to direct labour and direct material costs (e.g., service sector)
• Where there is a wide diversity of product range
• Where there are considerable differences in the use of resources by products
• Where consumption of resources is not driven by volume