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Activity Based Costing

Activity Based Costing

Cost accounting systems were originally developed primarily to assign costs to products for financial reporting purposes. Managers today want more from their cost accounting systems. Managers’ decisions drive an organization’s costs. To manage costs, managers and employees must understand how those decisions affect the efficiency of work being accomplished. ABC is a management accounting technique that assigns costs to the specific activities performed in a manufacturing or service delivery process. By learning what activities the organization uses to produce goods and services, managers can trace the organization’s costs to products via activities performed.

Activity Based Costing (ABC) attempts to trace costs more accurately to products or other cost objects than traditional costing methods. The cost of various activities then becomes the building blocks used to compile costs of products or other cost objects. Activity related costs are collected and cost drivers are chosen for each pool. Direct and indirect costs are then assigned to products or services using these activity-based cost pools and cost drivers. The information derived from ABC can be used with activity-based management to improve operations and minimize activities that do not add value to the organization.
Most organizations that use ABC have two costing systems – the official costing system that is used for preparing external financial reports and activity based costing system that is used for internal decision making and for managing activities.
Traditional absorption costing is designed to produce data for external financial reports. In contrast, activity based costing is designed to be used for internal decision making.

As a consequence, activity based costing differs from traditional cost accounting in four ways.
* Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis
* Some manufacturing costs may be excluded from product costs.
* Numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measures of activity.
* Cost of used capacity rather than cost of supplied capacity is captured. As a result, idle capacity is revealed for better capacity management.

Traditional cost accounting methods suffer from several defects that can result in distorted cost for decision making purposes. The advantage of a traditional costing system is its simplicity.

* All manufacturing costs-even those that are not caused by any specific products- are allocated to products.
* Nonmanufacturing costs that are caused by products are not assigned to products.
* They also allocate the costs of idle capacity to products. In effect, products are charged for resources that they don’t use
* They tend to place too much reliance on unit-level allocation bases such as direct labor and machine hours. Therefore,
* It results in over- costing high-volume more –complex products and under- costing low-volume less- complex products and can lead to mistakes when making decisions.

ABC Benefits:
* Increase awareness of cause-and-effect relationships
* Promote performance improvements
* Identify non-value-added activities.
* Motivate cost reduction
* Reduce arbitrariness in cost measurement
* Optimize use of constrained resources
* Capacity management
* Value-added pricing decision
* Analysis of product profitability