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Activity Based Costing Abc Is A Method Of Allocating Costs Accounting

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Introduction about Activity-Based Costing ( ABC )

Activity-Based Costing ( ABC ) is a method of apportioning costs to merchandises and services. Costss are assigned to specific activities-such as planning, technology, or manufacturing-and so the activities are associated with different merchandises or services. In such a manner, the ABC method enables a concern to make up one’s mind which merchandises, services, and resources are increasing their profitableness, and which are lending to losingss. It was besides developed as an attack to get the better of jobs associated with traditional cost direction systems in a more logical mode.

Traditional bing tend to hold the inability to accurately find existent production and service costs, or supply utile information for operating determinations. Therefore, directors can be exposed to doing determinations based on inaccurate informations. The higher exposure is for companies with multiple merchandises or services. To get the better of this defects, directors started utilizing ABC to delegate fabrication operating expense costs to merchandises. ABC has grown in importance in recent decennaries because

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Manufacturing operating expense costs have increased significantly.

The fabrication operating expense costs no longer correlate with the productive machine hours or direct labour hours.

The diverseness of merchandises to all merchandises.

How ABC benefits people?

Activity based bing allows directors to impute costs to activities and merchandises more accurately than traditional costs accounting methods. Besides, the activities responsible for the costs can be identified and passed on to users merely when the merchandise or service uses the activity. Following, ABC is an improved agencies of placing high operating expense costs per unit and happening ways to cut down the costs. Last, it provides directors with utile information and besides allows directors to see how to maximise company ‘s overall public presentation and implement profit-growth schemes.

How ABC works?

First, ABC place major activities in the procedure system. Following, cost pools are created for groups of activities that can be allocated together. Following this cost drivers are identified. The figure of cost drivers used vary depending on the truth and complexness of bring forthing that peculiar merchandises. After finding the cost drivers, rates are calculated. The rates are so applied to the several cost drivers for each merchandise or service that is being considered. Last, the overhead cost per unit is so derived by spliting the entire cost of the merchandise by the entire merchandise units.

Summary of ABC

1. Identify major activities

2. Make cost pools

3. Identify cost drivers

4. Calculate rates

5. Use rates to be drivers

6. Derive operating expense cost

per unit

Figure 1

Background surveies

Activity-based costing ( ABC ) is a managerial accounting system that identifies activities in a company and delegate the cost of each activity resource to all merchandises and services. The cost assigns are harmonizing to the cause and consequence relationship between cost object and activities incurred. The ABC method s allows an organisation to place which merchandises, and resources are increasing their profitableness and which are inefficient and need to be eliminated in order to cut cost. In traditional costing, a wide sum of disbursals had been added into the overhead cost. Causing the operating expense cost to be really overpriced. As the per centums of indirect cost had risen, this technique became inaccurate because the indirect costs were non caused same or every bit by all the merchandises and services.

The activity based costing is based on the George Staubus ‘ Activity Costing and Input-Output Accounting. During the 1970s and 1980s, the constructs of ABC were developed in the fabrication sector of the United States.At the same clip, the Consortium for Advanced Management-International, provided a formative function for analyzing and formalising the rules that have become more officially known as Activity-Based Costing.

In 1987, Robert Kaplan and Robin Cooper foremost introduced activity based as a chapter in their book Accounting and Management: A Field Study Perspective. They are focused on fabrication industry where betterment in engineering and productiveness have decrease the comparative proportion of the direct costs of labour and stuffs, but have increase the proportion of fabricating overhead costs. The upholder of the Balanced Scorecard, Robin Cooper and Robert S. Kaplan brought notice to these constructs in a figure of articles published in Harvard Business Review get downing in 1988. Cooper and Kaplan described ABC as an attack to work out the jobs of traditional costing system that unprofitable and inefficient. These traditional costing systems are frequently unable to find accurately the overhead costs of production and of the costs of related services. Based on the inaccurate information provided, the directors unable to do the right determinations particularly when there is more than one merchandise.

Alternatively of utilizing traditional costing that have wide arbitrary per centums to apportion costs.ABC seeks to objectively delegate costs to the merchandise or services based on the cause and consequence relationships. Once costs of the activities have been identified, the cost of each activity is attributed to each merchandise to the extent that the merchandise uses the activity. In this manner ABC frequently identifies countries of high operating expense costs per unit and so leads attending to happening ways to cut down the costs of merchandises.

In 1990, the first extension of ABC into fiscal establishments was in an article looking in the Journal of Bank Cost and Management Accounting ( Volume 3, Number 2 ) by Richard Sapp, David Crawford and Steven Rebishcke. Financial establishments besides have multiple merchandises and clients which can do cross-product cross-customer subsidies. Since force disbursals represent the largest individual constituent of non-interest disbursal in fiscal establishments, these costs must besides be assigned more accurately to merchandises or clients. In this and a subsequent article in 1991 in the same Journal ( Volume 4, Number 1 ) , the writers concluded that Activity based costing are more utile in apportioning the cost accurately compare than the traditional costing, this consequence that company more profitable.

While in 1999, activity-based costing was subsequently explained in the book Management Challenges of the twenty-first Century by Peter F. Drucker. He states that traditional cost accounting focuses on what it costs to make something. Activity-based costing records the costs that traditional cost accounting do non make.

Literature Review

Reasons for using ABC

First ground will be economic downswing that happened in the recent decennaries. ABC is back in popular demand, as companies are runing in a not-so-good economic system. They tend to concentrate more on their resources on bing clients, instead than seeking out new 1s. ABC helps them to divide the profitable 1s from the loss-making 1s and besides to calculate out ways to raise net incomes without holding to drastically raise monetary values of merchandises and services.

Second, it will be driver-based budgeting. Traditional excel-driven budgeting and planning, based mostly on intestine feel is now under onslaught for its deficiency of business-driven focal point. ABC is now seen as a subset of driver-based budgeting, instead than a distinguishable package application.

Last but non least, client intelligence and rating. Customer-centric sectors like banking and telecoms progressively realize that that turning their top-line ( i.e. organically ) besides means turning their client base or guaranting that their clients stay loyal. ABC helps by leting companies to better understand the value their clients bring to your bottom-line.

Implementation process of ABC

The execution stairss for the ABC is similar to those for a traditional ABC system. The chief difference lies in the finding of the entire cost for each activity ( Step 4 ) . This measure will be discussed in greater item, while staying stairss of the execution process will be discussed briefly.

Measure 1: Review the company ‘s fiscal information. About all of the needed fiscal information can be obtained from the company ‘s income statement and balance sheet.

Measure 2: Identify chief activities. Identify the chief activities depicting the fabrication and concern procedures of the company that consume runing resources or are responsible for capital investings.

Measure 3: Determine runing cost for each activity. Calculate the operating cost for each activity in the same manner as would be done for a traditional ABC execution. Costss should mirror overhead resource ingestion by each activity.

Measure 4: Determine capital charge for each activity utilizing Activity-Capital Dependence Analysis. This measure does non be in a traditional ABC computation. Since many activities consume non merely resources but besides capital investing, the full cost for many activities is higher than the cost calculated in an ABC system. As a consequence, ABC tends to undervalue the object cost. The integrated ABC-and-EVA system calculates the capital charge for activities demanding capital investings or tithing capital. This information is obtained by change overing informations on the company ‘s balance sheet into capital costs or charges. These capital charges are so added to the cost for each activity antecedently calculated by the ABC system.

Measure 5: Choice cost drivers. This measure is similar for a traditional ABC execution. Cost drivers are used to follow the cost of activities to merchandises based on their ingestion rate. Thus, runing cost drivers can follow operating costs and capital cost drivers can follow capital charges to the merchandises.

Measure 6: Calculate merchandise cost. Operating costs and capital costs are traced to the merchandises.

Potential booby traps of ABC

Harmonizing to the diary “ Learning to Love ABC. ” Journal of Accountancy. August 1999. by Cokins, Gary, companies that implement activity-based costing run the hazard of passing excessively much clip, attempt, and even money on assemblage and traveling over the informations that is collected. Too many inside informations can turn out thwarting for directors involved in ABC. On the other manus, a deficiency of item can take to deficient informations. Another obvious factor that tends to lend to the ruin of activity-based costing is the simple failure to move on the consequences that the informations provide. This by and large happens in concerns that were loath to seek ABC in the first topographic point.

In 1999, Gary Cokins wrote an article aimed at certified public comptrollers who have trouble praticing activity-based costing. In “ Learning to Love ABC, ” Cokins explains that activity-based bing normally works best with a minimal sum of item and estimated cost figures. He backs this up by saying that “ typically, when comptrollers try to use ABC, they strive for a degree of exactitude that is both hard to achieve and time-consuming-and that finally becomes the undertaking ‘s buss of decease. ”

In 2000, Cokins noted that “ activity-based costing undertakings frequently fail because undertaking directors ignore the central regulation: It is better to be about right than to be exactly inaccurate. When it comes to ABC, near sufficiency is non merely good plenty ; close adequate is frequently the secret to success. ” Cokins besides notes that the usage of mean cost rates, the usage of excessively detailed information, and the failure to link information to action can besides impede ABC undertakings. By understanding these constructs, Cokins feels that CPAs can heighten their functions as concern spouses and advisers.

Another modification factor is that activity-based bing package can be pricey. As Mark Henricks wrote in a 1999 article for Entrepreneur: “ Most ABC practicians find that special-purpose ABC package is required to do the undertaking manageable. At $ 6,000 and up for one bundle sold by ABC Technologies, package can add significantly to outlays for this type of accounting technique. There are, nevertheless, some pilot bundles available for $ 500. ”

Not merely that, clip can besides be a factor for concerns seeking a speedy hole. Henricks notes that “ although some companies see consequences about immediately, it typically takes three months or so for most concerns to see the benefits of ABC. And depending on your merchandise or concern rhythm, it could take much longer. ”

Theory related theory

ABC VS Traditional Costing

One chief related theory with ABC will be traditional costing. Now let ‘s do some comparing between traditional cost accounting and activity-based methods. First of all, traditional cost accounting looks at what is spent, while Activity-BasedA Methods expression at what is done in footings of activities.A If we focus on the latter, it is much easier to place chances to cut down costs and better public presentation, while keeping the quality of attention provided.

Traditional based bing systems typically use merely a individual operating expense pool – that is a individual accretion of costs that are non straight identifiable as merchandise portion costs or as labour. This would include supply and care disbursals, allotments of direction wages, depreciation, etc.

Activity based bing concentrate a batch of smaller more targeted cost buildups that are accumulated based on “ activities ” . Therefore, it is a more accurate manner of apportioning costs to merchandises.

Traditional Cost Systems:

Use cost allotment methods.

Do non concentrate on where or why costs occur.

Provide small penetration into the causes of discrepancies.

Information reported are largely accounting-oriented, inaccurate, non flexible and non seasonably.

Since the focal point is financial, it can non be easy understood by operational directors.

Do non tie in the cost of a merchandise or service with the existent attempt expended.

Activity-Based Costing ( ABC ) :

Based on existent public presentation, ingestion and disbursal informations extracted from the organisation ‘s bing information systems and combined with the cognition of those straight involved in the bringing of the merchandise or service.

Assign costs to activities based on the resources they consume.

Provides penetrations into the beginnings of costs and the possible impact of different determinations.

Provides the information required to take action and recognize public presentation discoveries.

Advantages & A ; Disadvantages of ABC

Activity based costing is a more accurate costing system, it brings a batch of advantages to the company and organisation comparison to traditional costing system. The first advantages activity based costing is it allocates the overhead cost more accurately, it control the costs at an single degree and on a departmental degree and happen out the unneeded cost. The director can do right determination based on the accurate information. The net income of a company besides increasing by utilizing this costing system through identifies unprofitable merchandises, sections and helps to apportion more resources on profitable merchandises. Furthermore, activity based bing focal point more on unit merchandise cost instead than the entire cost, this is easier to understand for internal and external user. In add-on, activity based costing is integrated good with six sigma and other uninterrupted betterment activities, it identify the non value added activities and supports public presentation direction and scorecards.

There are several restriction and disadvantages for this costing system. Implementing an ABC system in an organisation is a major undertaking that requires significant resources. Once implemented an activity based costing system is clip devouring to keep. Datas about multiple activity steps must be identified, checked, and recorded into the system. The others restriction is some overhead costs are hard to delegate to merchandises and clients. These costs are non assigned to merchandises or services because this will convey some mistake in the information, these cost should be met at the part of each merchandise and services. Besides, the disadvantages of this system is activity based bing informations must be used with attention when used in doing determinations and can be misinterpreted easy. Costss assigned to merchandises, clients and other cost objects are merely potentially relevant. Before doing any important determination utilizing activity based bing informations, directors must place which costs are truly relevant for the determinations at manus. In add-on, by and large accepted accounting rules ( GAAP ) do non conform the studies generated by this systems, an organisation involved in activity based costing should hold two cost systems, one for internal use and another for fixing external studies.

Major premises

Activity-based costing is a method that assigned cost to activities based on resource ingestion and so assigned to be objects based on activity incurred. There are six premise for activity based bing system.The first premise is activities consume resources ( and geting resources creates costs ) .The 2nd premise is the merchandises or clients consume activities. The 3rd premise provinces that ABC theoretical accounts ingestion instead than disbursement, this premise convey greatest impact, activity based costing does non acknowledge disbursement, but ingestion. The 4th premise is that there are legion causes for the ingestion of resources. These reflect a cause-and-effect relationship between cost object and activities incurred, because they enable multiple cost pools instead than merely one. The 5th premise is that cost pools are homogenous. This means that each cost pool has merely one activity. An ABC theoretical account would hold multiple cost pools in comparing to the traditional system. The 6th premise provinces that all costs in each cost pool are variable ( purely proportional to activity ) . This premise place that the lone fixed costs in a traditional cost system, all other costs would be associated with a variable activity.

Theory of restraint ( TOC )

The theory of restraints is one of a theory that can be comparing with ABC, it was developed by Goldratt and Fox in the 1980 ‘s. Goldratt developed a scheduling attack known as optimized production engineering ( OPT ) that used TOC principles.TOC is normally explained utilizing the Five Focusing Stairss. The chief intent of these stairss is to concentrate a director ‘s attending on the constraining resources, which advancing net income growing. The five stairss are:

1. Identify the system ‘s restraints.

A A A A A 2. Decide how to work the system ‘s restraints.

A A A A A 3. Subordinate everything else to the determination made in Step 2.

A A A A A 4. Promote the system ‘s restraints.

A A A A A 5. Travel back to Step 1 if the restraint is broken in Step 4.

There are a figure of premises underlying the theory of restraints. The first is that the end is to do money now and in the hereafter. . The 2nd premise provinces that throughput is used as a manner to mensurate money. Throughput is defined as gross minus the variable cost of stuffs and energy. The 3rd premise is that there is ever at least one restraint on each merchandise that limits the company ‘s gross. The 4th premise physiques on this constraint-there are three types of resources: scarce constriction resources, non-bottleneck resources, and capacity restraint resources. The 5th premise is that most fabricating operations have merely a few CCRs, and therefore it is easy to command them.

When comparing activity based bing with the theory of constrains it seen clearly that the ABC has a long tally skyline, while the TOC has a short-term skyline. The construct of short-term versus long tally looks at whether the measure of the production installation can be increased or decreased. These methods are based on several sets of premises with different clip skylines ; therefore that one attack is superior over the other should be abandoned. There is room for both attacks when they are used suitably. Accountants need to understand each tool and the manner they work in order to cognize when one is suited for the company and the other is non.

Components needed when ciphering ABC

Cost allotment

Cost allotment is a procedure of imputing cost to particular cost centres. For illustration the rewards of the driver of the buying section can be allocated to the buying section cost Centre. It is non necessary to portion the pay cost over several different cost centres. Cost and services are non indistinguishable to each other.

Cost allotment is the assignment of a common cost to several cost objects. For illustration, a company might apportion or delegate the cost of an expensive computing machine system to the three chief countries of the company that use the system. A company with merely one electric metre might apportion the electricity measure to several sections in the company.

Allotment implies that the assignment of the cost is slightly arbitrary. Some people describe the allotment as the spreading of cost, because of the arbitrary nature of the allotment. Attempts have been made over the old ages to better the bases for allotment. In fabrication, the overhead allotments have moved from plant-wide rates to departmental rates, from direct labour hours to machine hours to activity based costing. The end is to apportion or delegate the costs based on the root causes of the common costs alternatively of simply distributing the costs.

Fixed cost

Fixed costs are concern disbursals that are non dependent on the degree of goods or services produced by the concern. They tend to be time-related, such as wages or rents being paid per month. This is in contrast to variable costs, which are volume-related ( and are paid per measure produced ) . Fixed costs will non alter with the volume or production, unlike variable costs.

In direction accounting, fixed costs are defined as disbursals that do non alter as a map of the activity of a concern, within the relevant period. For illustration, a retail merchant must pay rent and public-service corporation measures irrespective of gross revenues.

Along with variable costs, fixed costs make up one of the two constituents of entire cost: entire cost is equal to repair costs plus variable costs.

Variable cost

Variable costs are disbursals that alteration in proportion to the activity of a concern. Variable cost is the amount of fringy costs over all units produced. It can besides be considered normal costs. Fixed costs and variable costs make up the two constituents of entire cost. Direct Costss, nevertheless, are costs that can easy be associated with a peculiar cost object. However, non all variable costs are direct costs. For illustration, variable fabrication operating expense costs are variable costs that are indirect costs, non direct costs. Variable costs are sometimes called unit-level costs as they vary with the figure of units produced.

Direct labour and operating expense are frequently called transition cost, while direct stuff and direct labour are frequently referred to as premier cost.

Cost driver

A “ cost driver ” is the unit of an activity that causes the alteration of an activity cost. A cost driver is any activity that causes a cost to be incurred. The Activity Based Costing ( ABC ) attack relates indirect cost to the activities that drive them to be incurred. In traditional bing the cost driver to apportion indirect cost to be objects was volume of end product. With the alteration in concern constructions, engineering and thereby cost constructions it was found that the volume of end product was non the lone cost driver. Some illustrations of indirect costs and their drivers are: care costs are indirect costs and the possible driver of this cost may be the figure of machine hours ; or, managing raw-material cost is another indirect cost that may be driven by the figure of orders received ; or, review costs that are driven by the figure of reviews or the hours of review or production tallies. By and large, the cost driver for short term indirect variable costs may be the volume of output/ activity ; but for long term indirect variable costs, the cost drivers will non be related to volume of output/ activity. To transport out a value concatenation analysis, ABC is a necessary tool. To transport out ABC, it is necessary that cost drivers are established for different cost pools.

Activity based costing is a more accurate costing system, it brings a batch of advantages to the company and organisation compared to the old traditional costing system. The first advantages activity based costing is it allocates the overhead cost more accurately, it control the costs at an single degree and on a departmental degree and happen out the unneeded cost. The director can do right determination based on the accurate information. The net income of a company besides increasing by utilizing this costing system through identifies unprofitable merchandises, sections and helps to apportion more resources on profitable merchandises. Furthermore, activity based bing focal point more on unit merchandise cost instead than the entire cost, this is easier to understand for internal and external user. In add-on, activity based costing is integrated good with six sigma and other uninterrupted betterment activities, it identify the non value added activities and supports public presentation direction and scorecards.


ABC costing is usually used in a more complex line of production, while traditional costing is largely used for simple productions. This survey above shows that the ABC methodological analysis can be applied successfully in all underdeveloped state presents. Estimates of clip allotment to all activities, including support and administrative activities, were all obtained in all sections and traced through the organisation and assigned to direct services, ensuing in estimations of the full unit costs of services.

ABC methodological analysis is enhanced by reiterating the survey sporadically and feeding the consequences into the direction determination doing procedure of the organisation. Due to the information provided by ABC, monetary values can be adjusted. This methodological analysis besides reveals the hidden costs associated with some non-value-added activities. ABC allows directors to mensurate the effectivity and fiscal impact of quality betterment ( QI ) plans and compare thee against their costs. In the nutshell, ABC is widely used presents due to the truth information it is able to supply to directors in helping them to do wise determinations that will convey the company more benefits.

Cite this Activity Based Costing Abc Is A Method Of Allocating Costs Accounting

Activity Based Costing Abc Is A Method Of Allocating Costs Accounting. (2016, Nov 27). Retrieved from https://graduateway.com/activity-based-costing-abc-is-a-method-of-allocating-costs-accounting-essay/

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