The basic factors which have prompted the development of Activity based costing (ABC System) may be summarized as follows: The process view provides operational (often non-financial) information about cost drivers, activities and performance.įactors Prompting the Development of Activity-Based Costing SystemĪctivity based costing System has developed basically on account of the limitations of the traditional absorption costing system.The cost assignment view provides information about resources, activities and cost objects.Using ABC, overhead costs are traced to products and services by identifying the resources, activities and their costs and quantities to produce output.Ī unit or output (a driver) is used to calculate the cost of each activity consumed during any given period of time.Īn activity based costing system can be viewed in two different ways: In contrast, Activity based costing (ABC) systems focus on activities required to produce each product or provide each service based on each product’s or service’s consumption of the activities. Typical attributes include the number of direct labor hours required to manufacture a unit, purchase cost of merchandise resold or the number of days occupied.Īllocations, therefore, vary directly with the ‘volume of units produced, cost of merchandise sold or days occupied by the customer. Traditional cost accounting techniques allocate costs to products based on attributes of a single unit. The basic distinction between traditional cost accounting and ABC is as follows: Difference Between Traditional Costing and Activity-Based Costing Thus, it is believed that activity-based costing helps in presenting a more realistic picture of the behavior of costs. The purchase requisition note is not raised in the purchasing department where most of the costs relating to procurement or purchase are incurred.Īctivity costs tend to behave in a similar manner to each other i.e., they have the same cost driver or the factor causing a change in the cost of an activity. The basic feature of functional departments is that they tend to include a series of different activities causing different costs that behave in different ways.įurther, the activities also tend to run across functions.įor example, the procurement or purchase of materials is made on the basis of a requisition note sent by a manufacturing department or stores. Thus, the activity based system system uses activities instead of functional departments (Cost Centers) for absorbing overheads. In traditional absorption costing, overheads are first assigned or related to cost centers, (production and service centers) and then to cost objects i.e., products or services.īut in Activity-based costing system, overheads are related or assigned to activities or grouped into cost pools before they are related to cost objects i.e., products or services. ABC System refined costing system by focusing on individual activities as the fundamental cost objects.Īn activity is an event, task or unit of work with a specified purpose e.g., designing products, setting up machines, operating machines and distributing products. Traditional cost systems allocate costs based on direct labor, material cost, revenue or other simplistic methods.Īs a result, traditional systems tend to over-cost high volume products, services and customers and under-cost low volume.Īctivity based costing should not be treated as an alternative to job costing or process costing but as one of the best tools for refining a costing system which provides a better measurement of the non-uniformity in the use of an organization’s overhead resources for job, products and services.Īctivity-based costing incorporates in its costing system the basic and vital role of different activities. Explanation of Activity-Based CostingĪctivity based Costing (ABC) is a systematic, cause & effect method of assigning the cost of activities to products, services, customers or any cost object.ĪBC is based on the principle that “products consume activities”. Moreover, Activity-Based Costing (ABC) has been developed as a more modern absorption costing method to overcome the problems of under-costing and over-costing and to produce more accurate product costs. Activity-Based Costing (ABC) - DefinitionĪn activity-based costing system (also known as ABC System) is a two-stage procedure for assigning overhead costs to products, which focuses on the major activities performed in the production process.Īctivity-based costing is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each.
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