Activity Based Costing

Introduction

Activity Based Costing (ABC) addresses internal operating concerns and is an augmentation to the traditional cost management system. It is not a replacement for traditional accounting, but makes use of the source documents provided from standard job costing systems. ABC looks at a business unit’s events as cost drivers and assigns all company resources and accumulated costs against those events in a time-phased sequence. Revenue tracking provides management with a different point of view on the profitability of products and services, providing insight into pricing. Middle management and technical performing organizations are involved in the line item reporting provided within the ABC system, enabling management to achieve more responsibility of reported information throughout all levels of the organization. ABC is being ostensible by the accounting industry as the wave of the future and is gaining broad acceptance within larger organizations. This system is intended to provide performing entities and management alike.

History of ABC

Activity Based Costing (ABC) is an approach to costing that considers the resources consumed by activities in order to create and deliver a product or service. It evolved in the mid-1980s to improve the allocation of manufacturing overhead costs to products, but it soon became apparent that activity-based costing systems could be expanded to include non-manufacturing costs (Langfield-Smith, Thorne & Hilton, 2004).

Review of ABC

Whereas the underlying assumption of a conventional costing system is simply that products cause costs, an activity based costing system assumes that cost objects (e.g. juice) creates the demand for activities (e.g. manufacturing), which in turn causes resources to be consumed (e.g. manufacturing time, outlet space, etc.) and causes costs. Cost objects are the reason for performing activities, and activities are the processes or procedures that cause work and create costs.

ABC analyses costs from the perception of the how much a particular activity costs, and the amount of resources consumed by the end product of the activity. Using activity based costing differs from traditional cost accounting in that the focus is on the activities that are required to produce an end product, rather than assuming that the volume of the end product is the only driver of costs.

A cost driver is a term used in activity-based costing. It simply refers to any activity that causes a cost. It can be anything from machine hours, labor hours, number of machine setups, or the number of parts in a product.

By understanding how resources are transformed into products or services, and by focusing on the cost of activities, ABC helps an organisation to obtain a greater understanding of how costs behave in their organisation and which activities create significant amounts of cost. Organisations can then begin to control their costs based on tangible activities rather than relatively uninformative general ledger or cost centre reports.

ABC is the assignment of costs from resources to activities and then from activities to cost objects:

ABC identifies the processes and activities involved in producing the cost object (e.g. fruit juice) and then cost these activities. The activities are cost by taking the traditional general ledger cost reports and determining an appropriate resource driver to assign the resource costs to the various activities. This involves accumulating costs that behave in a similar way into �cost pools’ (e.g. salary costs, machinery costs), and then identifying appropriate resource drivers to assign the costs from the cost pools to the activities (e.g. % of manufacturing time, factory space, etc).

The next step in ABC is to assign the activity costs to products