CIMA What is Activity Based Costing?

what is activity based costing

We can now use this to charge our supplier ordering costs to our product lines. So in total, we’ve got 280 batches across two different product lines. The final activity might be something along the lines of product inspections. Activity three is when we inspect our products to make sure they adhere to our quality standards. So, activity one is supply ordering and cost driver one is the number of supply orders.

what is activity based costing

Activity Based Management aims to maximize the value adding activities while minimizing or eliminating non-value adding activities in an organization. Its overall objective what is activity based costing is to improve efficiency and effectiveness of an organization in securing its markets. It depends heavily on Activities Based Costing as a source of its information.

What are the Steps of Activity-Based Costing?

These activities may be design changes, inspections, material movements, material requisitions, and machine setups. Duration drivers determine the duration of time required to perform an activity. Examples of duration drivers are set-up hours and inspection hours. It leads to more accurate cost information because of easy traceability of cost according to activities cost driver. Cost are pooled not on the basis of departments but according to the activities involved in the production.

what is activity based costing

Companies that use activity-based costing may identify hundreds of activities required to make their products. Predetermined Overhead Rate FormulaPredetermined Overhead Rate is that rate that is used to calculate an estimate on the projects which are yet to commence for overhead costs.

Activity Based Costing – 6 Factors Prompting the Development of ABC System

Activity-based costing is a costing methodology that assigns costs to activities and then assigns the cost of each activity to the products or services that are generated by that activity. ABC is a more accurate way to assign costs to products and services than traditional methods like job-based or overhead allocation. In traditional costing system, overhead costs are assumed to be influenced by only units produced. It means, in traditional costing system, cost of batch level, product level and facility level activities is fixed costs, i.e., costs of these do not change as production volume changes.

what is activity based costing

ABC is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. The information provided by analysing activities can support performance management provided it is used carefully and with full appreciation of its implications. Switching to ABC has implications for pricing, sales strategy, performance management and decision making. Dr. Uyen To Tran is a lecturer at Foreign Trade University, major in Accounting and Finance. She obtained her PhD in managerial accounting at Foreign Trade University in 2017. Her research interest and publications are in the area of financial accounting, managerial accounting, corporate finance, corporate governance. Identify and classify all of the activities in the value chain related to the production of the product.

Circumstances in which Activity Based Costing is Suitable for Product Costing

Thus, the larger the number of departments involved in the system, the greater the risk that data inputs will fail over time. This problem can be avoided by designing the system to only need information from the most supportive managers. Clearly, there are many valuable uses for the information provided by an ABC system. However, this information will only be available if you design the system to provide the specific set of data needed for each decision. If you install a generic ABC system and then use it for the above decisions, you may find that it does not provide the information that you need.

What is an example of activity-based costing?

Examples include square footage that is used per product, and the same would be used to allocate the rent of the factory as well as the maintenance cost of the firm; similarly, the number of purchase orders (i.e., PO) used to allocate the purchasing expenses of the purchasing department.

ABC helps managers to identify and control the cost of unused capacity. The final words of comment over ABC system are that adoption, implementation and operation of the system is not an end in itself. The benefits can be derived by translating the system design and its operation into action-oriented managerial performance. Ultimately, it amounts to effective cost management for the success of the system. Once processes are re-engineered, then the new costs must be tabulated.

Factors Prompting the Development of Activity-Based Costing System:

Leadership must also ensure the continued merging of finance, quality, and operations data and fight the urge to fall into old patterns that might feel easy and more familiar. Ensuring that all lines are accounted for can be very time-consuming and practically impossible for medium and large manufacturers. Implementation of ABC in service industry is difficult as the tracing of costs to service delivery may result in too many cost drivers. A limited number of cost drivers may not fully explain the cost behavior of different items in the cost pool. In some cases finding the activity that causes the cost is impractical.

Who invented activity-based costing?

Robert Kaplan is regarded as the founder of the theoretical principles of activity based costing within the cost management knowledge area. In the 1970s the activity based costing method was introduced in the manufacturing industry to solve the problems of traditional cost price calculation.

Thus, it is believed that activity-based costing helps in presenting a more realistic picture of the behavior of costs. With the time-driven approach, Hunter’s ABC team of analysts was able to group the three activities into a single departmental process, called inside sales order entry. The team learned that it took about 5 minutes to enter the basic order information, plus 3 minutes for each line item, and an additional 10 minutes if the order had to be expedited. If the customer were new, 15 more minutes would be required to set up the customer in the company’s computer system.

Leave a Reply