Activity Based Costing PDF

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ACTIVITY BASED COSTING 

TRADITIONAL ABSORPTION COSTING- production overheads are an integral part of production costs and should de absorbed into product cost. - Use a pre-determined Overhead Absorption Rate, - Uses Volume Related Bases, Traditional method involves the allocation of factory overheads based on the volume of production resources consumed, such as the amount of direct labour hours consumed, direct labour cost, or machine hours used. Overhead is allocated to each product based on the estimated pre-determined overhead rate and the number of unit in the selected activity base. Pre-determined Overhead Rate = estimated manufacturing overhead/ estimated activity base Manufacturing Overheads Costs – all cost other that Direct Materials, Direct Labour or selling and administrative costs. Once a company has determined the overhead, it must establish how to allocate the cost. Direct Materials – comprises the supplies used in manufacturing that can be traced to the product. Direct Labour – is the work used in manufacturing that can be traced to the product. Overheads – consist of Indirect Materials, Indirect Labour and other costs associated with the manufacturing process but not tied to a specific product. Indirect Materials – comprises the supplies used in production that can not be traced directly to an individual product. Indirect Labour – the work done by employees not directly involved in the manufacturing process. Because Indirect Costs cannot be traced directly to the product like Direct Costs are, they have to be allocated among all of the products produced. Advantages of traditional method: -

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all manufacturing costs are considered to be part of the product cost, whereas non-manufacturing costs are not costs are not considered to be production costs and are not assigned to product, regardless of whether the costs are based on the products, there is only one overheads cost pool and a single cost driver, which makes the traditional method simple and less costly to maintain. Therefore, the one overhead rate is consistent across products, but overhead may be over- or underapplied.

Disadvantages of traditional method: -

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the use of single cost driver doesn’t allocate overheads as accurately as using multiple cost drivers, the use of single cost driver may overallocate overheads to one product and underallocate overheads to another product, resulting in inaccurate total costs,

ACTIVITY BASED COSTING – overhead costs are caused by the support activities of an organisation/ is the process that assigns overheads to product based on the various activities that drive overheads costs. 1. ACTIVITIES – organisation’s major support activities/ any action that consumes company resources, such as taking orders for a product/ an action or process involved in the production of inventory. 2. COST POOLS – for each activity, group the budgeted costs together into cost pools, such a material handling costs/ a list of costs incurred when related activities are performed. 3. IDENTYFY COST DRIVER factors which make the cost of each activity increase are COST DRIVERS, such as number of requisitions. As the cost driver’s usage increases, the cost of overhead increases as well. Each cost driver will have has its own overhead rate which is why ABC is a more accurate method of allocating overheads. 4. CALCULATE COST DRIVER RATES = cost pool/ cost driver

5. CHARGE THE OVERHEADS TO THE PRODUCTS – multiply the cost driver rate for each activity by the usage of that cost driver for each product. In this way each product is charged with the overheads based on its usage of each activity. Activity Based Costing is an accounting method that recognizes the relationship between product costs and a product activity, such as the number of hours. It has an advantage over the traditional method because of the use of multiple activities as cost drivers. It is a five-stage process that allocate overheads more accurately than Traditional Absorption Method does by applying it to the products that use those activities. Works best in complex processes where the expenses are not driven by a single cost driver. Instead, several cost drivers are used as the overhead costs are analysed and grouped into activities and each activity is allocated based on each group’s cost driver. The five steps of ABC involve two major processes: - First, allocating overhead costs to the various activities to get a cost per activity, - Then, allocating the cost per activity to each product based on that product’s usage of the activities. Advantages: -

There are multiple overhead cost pools and cost drivers, this provides to more accurate rates for applying overheads, but it takes more time to implement and results in a higher cost, Both manufacturing and non-manufacturing costs may be assigned to product, More overheads can be traced back to the product, Leads to better pricing decisions, more accurate profit calculations, Should give a better understanding of overhead costs and how to reduce them, Should lead to more accurate costing of product,

Disadvantages: -

Can be too complex and expensive to run, as there is a cost to collect and cost driver to analyse as well as to allocate overhead on the basis on multiple cost drivers, Takes much more time to implement and operate, as information on cost drivers must be collected in an objective manner.

Traditional Absorption Costing – single cost driver; Optimal usage – when direct labour is a large portion of the product cost Activity Based Costing – multiple cost drivers; Optimal usage – when technology is a large portion of the product cost

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