Lecture 3: Activity Based Costing
In the last we lectures, we covered different techniques of allocating the indirect overheads.
However in both the plant wide overhead and departmental basis of allocation, we had a common
cost driver for multiple overheads. Departmental overhead rates (see lectures 1&2) will not correctly
assign overhead costs in situations where a company has a range of products that differ in volume,
batch size, or complexity of production. To make the costing more accurate and fair we use the
activity based costing method.
In the past most costs were labour cost as the economy was more manufacturing based. These days
almost all the processes are automated. This means that the associated overhead costs have
increased. This requires us to allocate our costs on more sophisticated basis such as activity based
costing.
It is up to the management to decide which type of costing would be the best for them. For example
if most of the costs incurred for a firm are labour, then departmental allocation would be well suited
for them. However if the firm has a lot of automation, activity based costing would be a better
method to allocate costs.
ABC systems:
Use sophisticated methods to allocate indirect costs to cost objects.
Used to measure both the cost of cost objects and the performance of activities.
Can help solve problems such as distorted product cost and poor cost control
And answer questions such as:
How much does it cost to supply resource capacity for each business process; and
How much resource capacity is required to perform work for each of our company’s
transactions, products and customers?
Steps in ABC:
Identifying the activities: this is one of the hardest part of the activity based costing as the
firm first has to identify what its activities are. We don’t want the system to be too complaex
by having a lot of activities or inaccurate by have too loe=w number of core activites.
Calculate total cost of the activity: it can be tricky to allocate which cost should be allocated
in which cost pool as now we have multiple cost pools not separated by the departments.
Identify the cost driver: identify what is causing the costs. For example if its quality control
costs, then how do we allocate them, number of quality checks or number of employees.
Calculate the cost driver rate.
Allocate the cost on the basis of usage.
When to use ABC:
In the last we lectures, we covered different techniques of allocating the indirect overheads.
However in both the plant wide overhead and departmental basis of allocation, we had a common
cost driver for multiple overheads. Departmental overhead rates (see lectures 1&2) will not correctly
assign overhead costs in situations where a company has a range of products that differ in volume,
batch size, or complexity of production. To make the costing more accurate and fair we use the
activity based costing method.
In the past most costs were labour cost as the economy was more manufacturing based. These days
almost all the processes are automated. This means that the associated overhead costs have
increased. This requires us to allocate our costs on more sophisticated basis such as activity based
costing.
It is up to the management to decide which type of costing would be the best for them. For example
if most of the costs incurred for a firm are labour, then departmental allocation would be well suited
for them. However if the firm has a lot of automation, activity based costing would be a better
method to allocate costs.
ABC systems:
Use sophisticated methods to allocate indirect costs to cost objects.
Used to measure both the cost of cost objects and the performance of activities.
Can help solve problems such as distorted product cost and poor cost control
And answer questions such as:
How much does it cost to supply resource capacity for each business process; and
How much resource capacity is required to perform work for each of our company’s
transactions, products and customers?
Steps in ABC:
Identifying the activities: this is one of the hardest part of the activity based costing as the
firm first has to identify what its activities are. We don’t want the system to be too complaex
by having a lot of activities or inaccurate by have too loe=w number of core activites.
Calculate total cost of the activity: it can be tricky to allocate which cost should be allocated
in which cost pool as now we have multiple cost pools not separated by the departments.
Identify the cost driver: identify what is causing the costs. For example if its quality control
costs, then how do we allocate them, number of quality checks or number of employees.
Calculate the cost driver rate.
Allocate the cost on the basis of usage.
When to use ABC:
