Activity-Based Costing

• One limit of traditional absorption costing is that overhead costs are uniformly assigned to one cost driver, which can reduce cost accuracy for businesses with a specialised production process
• If a business uses traditional absorption costing for a specialised production process, highly specialised, low-volume products will be under -cost while standardised, high-volume products will be over -cost
• Under Activity-Based Costing, the hierarchy of costs (from bottom to top) is unit, batch, product and facility.
• Activity-Based Costing was brought about after overhead costs had become over 1000% greater than labour costs, meaning that the value added from overhead was far greater than that from direct costs. A more accurate overhead allocation system would, therefore, be significantly beneficial.
• Under Activity-Based Costing, the relationship between products and overhead was linked to one of four transactions - logistical, balancing, quality and change.
• If most costs fall within the unit and facility level of activities, there is no point in moving to activity-based costing. This is because most of the total cost is made up of direct costs, so there is no benefit in recalculating overheads.
• If most costs fall within the batch and product level of activities, it would be beneficial to move to activity-based costing. This is because most of the total cost is made up of indirect costs, so recalculating overheads will provide a more accurate picture.
• Activity Cost Driver Rate = Activity Cost Pool Cost / Cost Driver Units
• Under ABC, if an activity does not lead to the production of the product, it is not charged to the product cost and instead expensed as period cost. Products are not charged for idle capacity, which provides more stable unit product costs.
• Assignment of Costs with Activity-Based Costing:

  1. Create activity cost pools
  2. Identify one cost driver for each cost pool
  3. Calculate the activity cost driver rate
  4. Activity cost is absorbed into the product using the activity cost driver rate
  5. Full production cost is calculated (absorbed overhead + prime cost)
• Under time-driven ABC, time is the only cost driver
• Time-driven activity-based costing (TDABC) reduces the need for data collection required to perform traditional ABC. This is particularly useful in the service sector.
• Under time-driven ABC, all overhead costs are grouped in the numerator, with time as the denominator.
• Under time-driven ABC, costs are distributed among the various activities based on how much time they take, and optimal time and slack time are then calculated at the end of the period.
• A company should switch to ABC when indirect costs are significant in proportion to direct costs
• A company should switch to ABC when their goods are complex and their production has many inputs and processes.
• A company should switch to ABC when complex, low -volume products are profitable, while standard, high -volume products are not.
• A company should switch to ABC if different departments believe costs are assigned inaccurately
• A company should switch to ABC if it loses bids for resources it thought were high and wins those it thought were low
• A company should switch to ABC if profits per unit increase, but net income declines
• One advantage of ABC is that it is fairer than traditional absorption, as overheads are absorbed through multiple activities
• One advantage of ABC is that it is a good base for determining resource allocation
• One advantage of ABC is that recognises the increasing importance of overheads, especially when they are a large proportion of total cost.
• One advantage of ABC is that it focuses on the true amount of time and resources taken up by various support activities, allowing for increased efficiency.
• One advantage of ABC is that it allows for more realistic pricing since costs are more accurately calculated
• One disadvantage of ABC is that it assumes linear cost behaviour because of the cost driver rate, which ignores economies & diseconomies of scale.
• One disadvantage of ABC is that it assumes there is only one cost pool for each cost driver
• One disadvantage of ABC is that it is rare that all overhead costs could be assigned to specific activities
• One disadvantage of ABC is that if wrong cost drivers are assigned, under-costing and over-costing can continue
• One disadvantage of ABC is that in order to use cost drivers, the activity must be quantifiable
• One disadvantage of ABC is that the costs of maintaining ABC can outweigh the benefits of the cost reductions
• One disadvantage of ABC is that it may be met with resistance to change due to judgment playing a part in cost allocation