Question

Explain the benefits of Activity Based Costing.

Please provide a comprehensive response to this question.

Answer 1

Activity Based Costing is the method of apportioning overheads based upon specific cost drivers.
Earlier the traditional system of overheads allocation was used in which ALL overheads were allocated on the basis of a common rate generally based upon direct labor hours.
But in Activity Based Costing, every overhead cost has a unique basis for allocation.
For example following overheads were incurred-
Rent 150000
Machine Maintenance cost 50000
Selling overheads 200000
Total 400000
Suppose total direct hours are 200000
Then, in traditional approach, a common rate of 20 (400000/200000) was used to apportion overheads.
But in Activity Based Costing,
Rent will be divided based upon area used.
Machine Maintenance cost shall be divided based upon no. Of labor hours.
Selling overheads shall be apportioned based upon the no. Of units sold.

The benefits of Activity Based Costing are as follows -

1. Activity Based Costing helps to accurately allocate each overhead to each product. Hence, it helps is forming an accurate pricing policy.

2. It provides accurate results to the management and hence helps the management in adopting productivity improvement approaches like TQM, BPR etc.

3. It helps to understand the overheads and cost drivers. It makes non - value adding activities clearly visible so that the management can work on eliminating them.

4. It helps to identify inefficient processes and improve them.

5. It helps to determine profit margins more accurately.