Question

Discuss Activity Based Costing.

• Explain what it is and how it differs from Job costing.
• Explain why “true” product costs have only a minor importance in final market price determination.
• Define and give an example of a “cost object”, “activity” and “resources.”
• Define “cost driver” and give 4 examples of activity cost pools and an appropriate cost driver for each.

Answer 1

In recent time Indirect cost of business has increased to a substantial level. Accordingly it was the need of the hour to introduce a better way to manage indirect cost. Historically when indirect cost were at minimal level of Total Cost at that point absorption costing was used. However in recent time since Indirect cost have increased so, we have introduced a better way of technique called Activity based costing.

Traditionally, in a job order cost system, overhead is allocated to a job or function based on a specific basis like direct labor hours, machine hours, or direct labor dollars. However, new technologies have changed the manufacturing environment such that the number of hours worked or dollars earned by employees are no longer good indicators of how much overhead will be needed to complete a job or process products through a particular function. In Activity based costing first, we identify the activity then create a cost pool, then select a cost driver, then we find out the cost driver rate and finally charge the indirect expense to the product based on Cost Driver Rate.

True cost economics is most often applied to the production of commodities and represents the difference between the market price of a commodity and total societal cost of that commodity, such as how it may negatively affect the environment or public health (negative externalities). The concept also may be applied to unseen benefits otherwise known as positive externalities such as how the pollination of plants by bees has an overall positive effect on the environment at no cost.

Cost object is a term used primarily in cost accounting to describe something to which costs are assigned. Common examples of cost objects are: product lines, geographic territories, customers, departments or anything else for which management would like to quantify cost. Activity is functions of an entity like Purchasing, Material Handling, Inspection etc. Resource is basically the activity in whih cost is incurred.