Question

Describe activity based costing. a. Give two examples where activity based costing is preferable over traditional costing. b. How is activity-based costing useful for decision making? c. Discuss the three overhead rate methods used in activity-based costing and consider their relative usefulness.

Answer 1

ACTIVITY BASED COSTING(ABC) IS A METHOD FOR ASSIGNING COSTS FOR TO PRODUCTS, SERVICES , PROJECTS , TASKS OR ACQUISTIONS BASED ON i)ACTIVITIES THAT GOES INTO THEM ii)RESOURCES CONSUMED BY THESE ACTIVITIES.

THE BASIC IDEA OF ABC IS THAT COSTS ARE GROUPED ACCORDING TO WHAT DRIVES THEM OR CAUSES THEM TO BE INCURRED. THE COST DRIVERS ARE THEN USED AS AN ABSORPTION BASE

a) EXAMPLE 1:THE PRESENT COSTING SYSTEM(TRADITIONAL COSTING) HAS DEVELOPED CONVENIENT OVERHEAD RECCOVERY BASIS AND BLANKET OVERHEAD RECOVERY ARE ACCEPTABLE WHEN VALUING STOCKS FOR FINANCIAL REPORTING , BUT THEY ARE INNAPROPRIATE WHEN USED FOR DECISION MAKING AND TYPICAL PRODUCT STRATEGY DECISIONS. SUCH DECISIONS HAVE IMPLICATIONS OVER 3-5 YEARS AND OVER THIS PERIOD MANY FIXED COSTS BECOME VARIABLE

EXAMPLE 2:IN CASE OF COMPANIES MANUFACTURING AND SELLING MULTIPLE PRODUCTS USUSALLY MAKE DECISIONS ON PRICING PRODUCT MIX , PROCESS TECHNOLOGY , ETC, BASED ON DISTORTED COST INFORMATION DUE TO DIFFICULTIES IN TRADITIONAL COSTING SYSTEM IN COLLECTION, CLASSIFICATION , ALLOCATION AND RECOVERY OF OVERHEADS TO INDIVIDUAL PRODUCTS

THUS TO OVERCOME THE INADEQUACIES OF TRADITIONAL METHODS OF OVERHEAD ABSORPTION AND SHORT-TERM BIASING OF MARGINAL COSTING , ACTIVITY BASED COSTING HAS BEEN RESEARCHED WHERE COST DRIVERS ARE THEN USED AS AN ABSORPTION BASE.

b)THE ASSUMPTION UNDERLYING ABC IS THAT VIRTUALLY ALL OF A COMPANY'S ACTIVITIES EXIST TO SUPPORT THE PRODUCTION AND DELIVERY OF GOODS AND SERVICES.THEY SHOULD THEREFORE ALL BE CONSIDERED AS PRODUCT COSTS AND BECAUSE NEARLY ALL FACTORY AND CORPORATE SUPPORT COSTS ARE SEPERABLE , THEY CAN BE SPLIT APART AND TRACED TO INDIVIDUAL PRODUCT OR PRODUCT FAMILIES. ON THE BASIS OF ASSUMPTION THE PHILISOPHY OF ABC IS THAT COSTS CAN BE CONTROLLED MORE EFFECTIVELY BY FOCUSING DIRECTLY ON MANAGING THE FORCES THAT CAUSE THE ACTIVITIES THE COST-DRIVERS RATHER THAN COST.THE REPORTING OF COSTS CONSUMED BY THE SIGNIFICANT ACTIVITIES OF BUSINESS AND THEIR COST DRIVERS , PROVIDES THE BASIS FOR UNERSTANDING WHA CAUSES OVERHEAD COSTS AND DIRECCTS ATTENTION TO WHERE STEPS CAN BE TAKEN TO IMPROVE PROFITABILITY , KNOWING THE HIGH COSTS OF MATERIAL MOVEMENTS OR THE COST OF PRODUCING MANY DIFFERNET COMPONENTS OR MAINTAINING MANY DIFFERENT MACHINES, HIGHLIGHTS THE NEED TO CARRY OUT THESE ACTIVITIES MORE EFFECTIVELY.THUS ABC PROVIDES BETTER AND MORE ACCURATE INFORMATION FOR DECISON MAKING ON PRICES AND PRODUCT MIX AND FOR CONTROL OF MANUFACTURING OPERATIONS

c)Activity costing allocates the expense on the premise of movement and the cost driver of activity.It allocates the overhead to different movement expense pools. The three overhead rate method utilized as a part of ABC are overhead in light of the premise of direct material, direct labor and overhead rate on the premise of power consumed. The overhead rate in activity based costing can be processed as follows:

Overhead rate on the basis of no. of labour hours=Total cost/Total number of labour per hours

Overhead rate on the basis of direct material used= Total cost/Total material utilized

Overhead rate on the basis of electricity unit consumed= Total electricity charge/Total unit

These overhead rates are utilized to compute the overhead cost of any organization and designate taken a toll for compelling cost management. Because of these overhead rate which are utilized to figure the taken a toll according to the activity, ABC can give precise result in costing of material, labour and overhead to minimize the costs and earn profit