Abc- Activity Based Costing

1a) Activity based costing is a relatively new type of procedure that can be used as an inventory valuation method. The technique was developed to provide more accurate product costs. This improved accuracy is accomplished by tracing costs to products through activities. In other words, costs are traced to activities (activity costing) and then these costs are traced, in a second stage, to the products that use the activities. Another way to express the idea is to say that activities consume resources and products consume activities. Essentially, an attempt is made to treat all costs as variable, recognizing that all costs vary with something, whether it is production volume or some non-production volume related phenomenon. Both manufacturing costs and selling and administrative costs are traced to products in an ABC system. In traditional full absorption costing and direct (or variable) costing systems, indirect manufacturing costs are allocated to products on the basis of a production volume related measurement such as direct labour hours. Thus, the fundamental differences between traditional systems and activity based systems are:

1) How the indirect costs are assigned (ABC uses both production volume and non-production volume related bases) and

2) Which costs are assigned to products (in ABC systems, an attempt is made to assign all costs to products including engineering, marketing, distribution and administrative costs, although some facility related costs may not be assigned).

Other differences:

* In activity based costing both manufacturing as well as non-manufacturing costs are assigned to products while with traditional costing systems only manufacturing costs are assigned.

* In ABC certain manufacturing costs may be left out from costing the products while with traditional all manufacturing costs are included.

* In ABC costs are allocated through cost pools.

* There are different cost allocation bases.

* In ABC the rates used are based on the capacity while in traditional they use a budgeted level.

How does Activity Based Costing differ from traditional cost accounting systems?

Most traditional costing systems utilize a single basis, (e.g. direct labour) to distribute the indirect costs to all products and services. This method of allocating indirect costs commonly results in erroneous cost data. Often products which have high volume (and high labour cost) are over costed. Likewise, the cost of lower volume products are often understated, and many of the indirect costs of these products are overlooked.

Rather than relying on a single basis to distribute costs, ABC assigns costs to activities and products based on how the costs (resources) are actually consumed by the process or product. By moving away from traditional cost allocation methods and using improved ABC methods of tracing and assignment, ABC provides managers with a clearer picture of cost of processes and the profitability of customers and products.

Activity based costing is based on the following ideas. First, designing, producing and distributing products and services requires many activities to be performed. Performing these activities requires resources to be purchased and used. Purchasing and using resources causes costs to be incurred. Restated in reverse order, the ABC logic is that resources generate costs, activities consume resources and products consume activities. Thus, a company's activities are identified, then costs are traced to these activities (or activity cost pools) based on the resources that they require. Then, costs are assigned, or traced from each of these activity cost pools to the company's products (or services) in proportion to the demands that each product (or service) places on each activity. In ABC, a measure of the relevant activity volume is used to trace each type of costs, rather than exclusively using measurements (or allocation bases) related to the volume of the products or services produced. Using this logic, ABC tends to solve the problems created by traditional cost or inventory valuation methods.

Example: the difference between product costs when using Traditional and ABC

Company A manufactures two products:

Product H - a high volume product, and

Product L - a low volume product.

Information regarding the production and costs of activities is as follows:

Product L Product H

Machine hours per unit 2 2

Labour hours per unit 4 4

Annual output (units) 1 000 10 000

Total machine hours 2 000 20 000

Total labour hours 4 000 40 000

No. of purchase orders 80 160

No. of machine set-ups 40 60

The cost of the activities was as follows:

R

Volume related costs 110 000

Purchase related costs 120 000

Set-up related costs 210 000

440 000

(a) Traditional volume-based costing system

Total costs for allocation: 440 000

Overhead rate per machine hour:

440 000/22 000 = R20/hour

Overhead rate per labour hour:

440 000/44 000= R10/hour

Machine hour Labour hour

Cost per unit: L 2x20= 40 4x10= 40

H 2x20= 40 4x10= 40

Total