Question

What do you understand by ABC? Explain the process used to assign costs in an ABC system

Answer 1

Activity based costing is the costing technique in which cost are allocated between different products or departments on the basis of activities involved in it. We can understand Activity based costing with the help of difference between Traditional costing Activity based costing.

In the System of traditional or absorption costing, overhead can be recovered on the basis of any of following method:

a.) on the basis of Outputs.

b.) on the basis of Material Cost.

c.) on the basis of Labor Cost.

d.) on the basis of Prime Cost.

e.) on the basis of Labor Hours.

f.) on the basis of Machine Hours.

We should identify fixed overhead to the product on the basis of activity involved instead of single recovery rate (Blanket rate).In other words, we can say-

(i) If a product does not consume any activity then that product should not absorb any part of overhead of that activity.

(ii) If a product consumes high volume of activity, then that product should absorb higher amount of overhead of that activity.

This System is known as Activity Based Costing .This system of ABC would reflect a better position of individual product profitability as compare to absorption.

In Activity based costing, cost driver is identified and then cost is allocated to different departments or products. Cost driver is a method of computing costs associated with each product in a company based on the amount of resources consumed by each activity.

We can understand the process of allocating overhead under ABC with the help of an example.

Two possible cost drivers in business are Total direct labour hours and number of orders. For example, Say we have total ordering cost of $10000 and we need to allocate ordering cost between 3 products say A,B,C and D. Now we need to determine the cost driver on the basis of which ordering cost will be allocated between 4 products. For ordering cost, cost driver will be number of orders of every product. Now on the basis of number of orders, ordering cost of $10000 will be allocated between 4 products.

Another cost driver is direct labour hours. Say company is produced 4 products A, B, C and D. Total direct labor cost is $100000 and we need to divide direct labor cost between 4 products. Here cost driver for allocating direct labor cost will be direct labour hours. Here we need to allocate direct labour cost of $100000 between 4 products on the basis of number of direct labour hours taken by each product.