Meaning of Activity Based Costing (ABC)
Activity Based Costing is an accounting methodology used for assigning accurately the extent of resources consumed and overhead costs incurred to produce a product or service on the basis of value adding activities.
Definition of Activity Based Costing
Definition by CIMA,
Cost attribution to cost units on the basis of benefit received from indirect activities e.g. ordering, setting up, assuring quality.
Definition by CAM-1 Organization of Arlinton Texas,
The collection of financial and operation performance information tracing the significant activities of the firm to product costs.
Kaplan and Cooper’s ABC
Kaplan and Cooper of Harvard Business School who have developed new accounting methodology in costing to calculate product costs. They classify the costs into two types. They are
- Short term variable costs and
- Long term variable costs.
The reason is that all the costs are variable in the long run. But, only variable costs are variable in the short term. Fixed costs i.e. long term variable costs are varying but not immediately.
For example production scheduling costs can be changed in the long term by changing number of runs rather than changing number of units produced.
Under ABC system, some activities are responsible for the determination of cost of a product. They are named cost drivers. A cost driver is an activity which generates cost.
Features or Characteristics of Activity Based Costing
The features or characteristics of Activity Based Costing are briefly explained below.
1. The total cost is divided into two types i.e. fixed cost and variable cost which is necessary to provide quality information to design a suitable cost system in a manufacturing concern.
2. The proper distinction is made between the cost behavior patterns.
3. The cost behavior patterns are volume related, diversity related, events related and time related.
4. The appropriate cost driver has to be identified for tracing the overhead to a product.
5. The cost drivers dictate the cost behavior pattern.
Allocation of Overheads under Activity Based Costing
Under Activity Based Costing, the costs are classified as short term variable costs and long term variable costs.
The short term variable costs are allocated to the products on the basis of volume related cost drivers. Direct labour hour, Direct material cost and machine hours are some of the examples of volume related cost drivers.
According to Kalpan and Cooper, volume related cost drivers can not be used for allocating long term variable costs to products. The reason is that the long term variable costs are driven by the complexity and variety of business activities rather than by volume.
Hence, the causes for the overhead costs should be understood in line with the types of activities connected with the production department and service departments. The following figure discloses the way of allocation of overhead under ABC.
Objectives of Activity Based Costing
The objectives of Activity Based Costing are given below.
1. To rectify the inaccurate cost information.
2. To allocate the overheads on activity basis.
3. To help the management in taking quality and timely decision.
Development of Activity Based Costing
The development of Activity Based Costing involves the following steps.
1. The main functional areas of the organization have been identified. For example production, sales, distribution etc.
2. Each functional area has separate activities. Out of many activities, the main activities of each functional areas have been identified. For example: Purchase of raw materials, purchase of packing materials etc.
3. The support activities of main activities have been identified. For example: repairs and maintenance of machine, maintaining power supply, testing of quality etc.
4. The factors which are influencing the main activities and support activities identified i.e. cost drivers.
5. The data relating to direct labour, material and overhead costs have been collected accurately.
6. The cost driver rates have been fixed on the basis of the overheads incurred.
7. The cost of each activity is also find out in order to calculate the cost of each product separately.
Thus, ABC is the process of tracing costs first from resources to activities and then from activities to specific products.
Implementation of Activity Based Costing
The following steps are involved in implementing Activity Based Costing to achieve the desired results.
1. Identify the functional areas of organization.
2. Identify the main activities of each functional areas.
3. Allocate common indirect costs to each functional areas on suitable basis.
4. Identify the most suitable cost driver in each activity under functional areas.
5. Preparing the statement of expenditure on activity wise.
6. Compare this statement with the value addition activity wise.
7. Find the activities which are to be eliminated or improved for better performance of the organization.