Question

Explain activity-based costing. Choose two (2) manufacturing companies and explain why these companies would benefit from using an activity based costing system.

Answer 1

ACTIVITY BASED COSTING:-

• The activity based costing (ABC) is a costing system, which focuses on activities performed to produce products.
• ABC is that costing in which costs are traced to activities and then to products.
• This costing system assumes that activities are responsible for the incurrence of costs and create the demands for activities.
• E.g:-an accounting firm prepares tax returns,a University teaches students

DEFINTIONS OF ACTIVITY BASED COSTING:-

CIMA defines ACTIVITY BASED COSTING AS FOLLOWS,

"Cost attribution to cost units on the basis of benefit received from indirect activities e.g., ordering,setting up,assuring quality."

ABC has also been defined by CAM-1 organisation of Arlinton Texas as

"the collection of financial and operation performance information tracing the significant activities os the firm to product costs".

EVOLUTION OF ACTIVITYT BASED COSTING SYSTEM:-

• ABC system is developed due to many deficiencies of Traditional Cost Systems, which lead to the discovery of the ABC system.

• The concept of ABC were developed in the manufacturing sector of the United states during the 1970's and 1980's.
• During this time , the consortium for avanced manufacturing-International, now known simply as CAM-I, provided a formative role for the studying and formalizing the principles that have become more formally known as Activity Based Costing.

OBJECTIVES OF ACTIVITY BASED COSTING:-

The objectives of Activity Based Costing are as follows:

• To improve product costing.
• To identify non-value adding activities in the production process which might be a suitable focus for attention or elimination.
• To provide required information for decision making.
• To reduce the frivolous (non essential) use of common resources.
• To encourage managers to evaluate the efficiency of internally provided services.
• To calculate the full cost of products for financal reporting purposes and for determining cost-based prices.

USES OF ACTIVITY BASED COSTING:-

The areas in which activity based information is used for decision making are as follows:-

• Activity costs:- ABC is designed to track the cost of activities, so we can use it to see if activity costs are in line with industry standards.
• Distrubution costs:- Organisation uses a variety of of distribtion cahnnels to sell the products, such as retail,internet, distributors, and mail order catalogs. Most of the structural cost of maitaining a distribution channel is overhead , so if we make a reasonable determination of which distribution channels are using overhead, we can make decisions to alter how distribution channels are used, or even to drop unprofitable channels.
• Make or buy:-ABC enables the manager to decide whether he should get the activity done within the firm or outsource the same. Outsourcing may be done if the firm is incurring higher overhead costs as compared to the outsourcer or vice-versa.
• Margins:-With proper overhead allocation from an ABC sysytem, we can determine the margins of various products, product lines, and entire subsidiaries. This can be quite useful for determining where to position company resourcesto earn the largest margins.
• Product facility cost:-It is usually quite easy to segregate overhead costs at the plant-wide level,so we can compare the costs of production between different facilities.