topic 33 activity based costing

• ABC identifies the activity which influences each indirect cost. The cost per unit of output is then calculated based on its use of this activity
• CIMA definition of ABC is cost attribution to cost units on the basis of benefits received from indirect activities
• Cost pool is equivalent to the cost centre for each activity. ABC analyses an organisation's indirect activities into groups of costs, one group for each major activity. These groups are known as cost pools
• Cost drivers are the factors which cause costs to be incurred and to change
• Overhead/cost rate is calculated by: cost pool/cost driver = cost rate
• Steps:

  -identify activities required to complete products

  -prepare a cost pool for the activities identified in step 1

  -identify the cost driver for each activity

  -calculate a cost rate for each activity

  -allocate overhead costs to products
• Advantages of ABC compared to absorption costing

  • Absorption costing shares costs among a firm's different products based on OARS linked to the production process and is suitable for traditional style manufacturing
  • The growth of service industry and new technology in manufacturing means that indirect costs represent a rising proportion of total costs, with little or no emphasis on machine hours or direct labour time
  • Modern integrated production systems can now often operate with minimal human intervention eg. automated methods of mass production
• Advantages of ABC compared to absorption costing

  • Indirect costs can now account for the majority of product costs and should therefore be accounted for in a less arbitrary way than they would under absorption costing
  • Production methods and batch sizes can have a major impact on product costs yet these are mainly ignored by absorption costing
  • ABC is therefore more suitable than absorption costing to firms which produce a diverse range of products, where products differ greatly in volume and manufacturing complexity and products lines require differing degrees of support services
• Advantages of ABC compared to absorption costing

  • More accurate cost information leads to better decisions
  • Increased knowledge of production activities leads to process improvements and reduced costs
• Disadvantages of ABC compared to absorption costing

  • ABC systems can be costly to implement
  • The benefits may not outweigh the costs
  • There are still cost pools that are not caused by one particular cost driver but by several