Question

Discuss in 5 - 6 paragraphs what is Activity based costing in Accounting. How does it help to run a business. And how does the ABC system improves the costing process?

Answer 1

Activity Based Costing is a method of accounting which assigns costs to products by identifying activities that a firm conducts. It assigns cost of each activity along with the resources used in all products and services.

In this system, activities that consume resources are the cost drivers . It does not allocate costs to cost centers like marketing, manufacturing, finance, instead it allocates direct costs and indirect costs to the activities of the products such as setting up a machine, attending to a complaint of customer, or processing an order.

ABC system is an alternative to traditional accounting system wherein the business overheads such as indirect costs like heating, lighting and marketing are allocated in proportion to the direct costs of the activity. This is not satisfactory because the two activities that have the same amount of direct costs can use different amount of overhead costs. For example, the mass production of industrial robot can consume the same amount of labour and materials as used in production of customised robot. But the production of customised robot uses more of the company's engineer time, which is an overhead, than the production of mass robot.

Here, the traditional system would not reflect the difference. And so the company that produces more of customised products will soon find itself in making huge losses. Thus, the importance of indirect costs increases, with the new technologies making easier for companies to customise products. And this is how, ABC system helps run a business.

ABC system helps improves the costing process. It enhances three ways of costing process. Firstly, it assigns costs by activity, instead of allocating all costs in pool as a whole. It assigns different number of cost pools which can be used to allocate overhead costs. Secondly, it also creates new bases for allocating overhead costs to products such that the cost of activities are allocated instead of volume measures like direct labor or machine hours. And finally, Activity Based Costing system changes the nature of certain indirect costs, making costs considered indirect previously.