ACTIVITY BASED COSTING

Activity Based Costing

Activity Based Costing

Introduction

Activity-based costing, initiated and popularized by Robin Cooper and Robert S. Kaplan, can solve these distorted problems (Cokins, 2006). Activity-based costing (ABC) is defined as the collection of financial and operation performance tracing the significant activities of the firm-to-product cost. Conventional cost systems can report seriously distorted product costs when the products that are manufactured are diverse. In particular, size and batch-size diversity can affect the accuracy of reported product costs. Activity-based costing (ABC) is the answer. It is a development in product costing that has attracted much attention in the last few years.

Conventional cost accounting systems focus on units of particular products. Costs are allocated or “traced” to a product because each unit is assumed to consume resources. Therefore, conventional allocation bases measure only attributes of a unit, for example, the number of direct labour hours, machine hours or material costs consumed in making the product. By contrast, ABC systems focus on the activities performed to produce products in the manufacturing process. Costs are traced from activities to products based on each product's consumption of the activities performed (Cokins, 2006). ABC acknowledges that products or services do not directly use up resources; they use up activities. ABC systems differ from traditional cost accounting systems in the nature of cost drivers used to trace costs. (Nejati, Shafaei & Nejati, 2008)

Traditional, unit-based cost accounting systems use only second-stage allocation bases, which are based on unit-level characteristics of the product. Typically, direct labour hours, machine hours and material costs are the allocation bases used. Allocation bases that measure characteristics of the product are called “unit-level allocation bases”. An ABC system, on the other hand, uses cost drivers that are related to unit-level, batch-level and product-level characteristics. Examples of batch-level bases include set-up hours and number of set-ups. Examples of product-level bases include number of parts, number of times ordered and number of engineering charge orders.

The three key areas of ABC are product cost differentiation, activities and their cost drivers, and identification of non-value-added cost improvement opportunities (Nejati, Shafaei & Nejati, 2008). ABC assigns product costs based on the activities that a product draws on. An activity may be defined as a particular operation in the production cycle, or it could be defined as the entire material acquisition process. Activities use resources such as support labour, technology cells or utilities. The agents that cause activities to happen are called cost drivers. The identification, measurement and control of cost drivers is essential to ABC. Resource costs (power, set-up, material handling and supervision) analysed and identified are traced to cost pools identified within activity centres through the use of first-stage cost drivers. Because activity centres represent different segments of the production process (activities), the total cost of each activity centre is the dollar sum of all the cost pools traced from all resources. The cost pools in each activity centre are then relieved by second-stage cost drivers, which trace their consumption or use to ...