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Activity Based Costing

(What is activity based costing (ABC), Treatment of costs, Implementation, and Limitations of activity based costing)

What is Activity based costing:

Activity based costing is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore "fixed cost". Activity based costing is used to determine product costs for special management reports. Activity based costing is ordinarily used as a supplement to the company's usual costing system. Most organizations that use activity-based costing have two costing systems-the official costing system that is used for preparing external financial reports and the activity based costing system that is used for internal decision making and for managing activities.

In activity based costing the objective is to understand overhead and the profitability of products and customers and to manage overhead. As a consequence of these differences in objectives, "best practice" activity based costing differs in a number of ways from traditional cost accounting. In activity based costing:

2.Some manufacturing costs may be excluded from product costs.

4.The allocation bases often differ from those used in traditional costing system.

Treatment of Costs under Activity Based Costing:

Nonmanufacturing Costs and Activity Based Costing:

In traditional cost accounting system, only manufacturing costs are assigned  to products. Selling, general, and administrative expenses are treated as period costs and are not assigned to products. In activity based costing, products are assigned all of the costs-nonmanufacturing and manufacturing-that they can reasonably be supposed to have caused. The entire cost of the product is determined rather than just its manufacturing cost.

Manufacturing Costs and Activity Based Costing:

In traditional cost accounting, all manufacturing costs are assigned to products-even manufacturing costs that are not caused by the products. For example a portion of the factory security guard's wages would be allocated to each product even though the guards wages are totally unaffected by which products are made or not made during a period. In activity based costing, A cost is assigned to a product only if there is a good reason to believe that the cost would be affected by decisions concerning the product.

The cost of Idle Capacity in Activity Based Costing:

In Traditional cost accounting, predetermined overhead rates are computed by dividing budgeted overhead costs by a measure of budgeted activity such as budgeted direct labor hours. This results in applying the costs of unused, or idle, capacity to products, and it results in unstable unit product cost.

In contrast to traditional cost accounting, in activity based costing, products are charged for the costs of capacity they use and not for the costs of capacity they do not use. The costs of idle capacity is not charged to products in activity based costing.

Steps for implementing Activity Based Costing

1. Identify and define activities and activity cost pools
2. When ever possible, directly trace costs to activities and cost objects.
3. Assign costs to activity cost pools
4. Calculate activity rates.
5. Assign costs to cost objects using the activity rates and activity measures.
6. prepare management report.

Limitations of Activity Based Costing:

1. Implementing an activity based costing system is a major project that requires substantial resources. Once implemented   an activity based costing is costly to maintain. Data concerning numerous activity measures must be collected , checked, and entered into the system.
2. Activity based costing produces numbers such as product margins, that are odds with the numbers produced by traditional costing systems. But managers are accustomed to using traditional costing systems to run theirs operations and traditional costing systems are often used in performance evaluations.
3. Activity based costing data can easily be misinterpreted and must be used with care when used in making decisions. Costs assigned to products, customers and other cost objects are only potentially relevant. Before making any significant decision using activity based costing data, managers must identify which costs are really relevant for the decisions at hand.
4. Reports generated in activity based costing systems do not conform to generally accepted accounting principles. Consequently, an organization involved in activity based costing should have two cost systems-one for internal use and one for preparing external reports

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