Activity Based Costing (ABC)
ABC - answerA costing method that assumes the steps or activities that must be
followed to manufacture a product are what determine the overheads incurred
Overheads used to be small - answerProduction overheads such as machine
depreciation, will have been a small proportion of overall costs. This is because
production was more labour intensive and, as a result, direct costs would have been
much higher than indirect costs. A rough estimate of the production overhead per unit
was therefore fine.
Overheads are now a larger proportion of total costs - answerManufacturing has
become more machine intensive and, as a result, the proportion of production
overheads, compared to direct costs, has increased. Therefore, it is important that an
accurate estimate is made of the production overhead per unit.
The nature of manufacturing has changed. - answerMany companies must now operate
in a highly competitive environment and, as a result, the diversity and complexity of
products has increased.
Differential Cost - answerThe difference between the cost of two alternative decisions,
or of a change in output levels. Example of alternative decisions. If you have to decide
between a cost of $1,200,000, and $1,400,000, then the differential cost between the
two alternatives is $200,000.
Opportunity Cost - answerThe cost of other alternatives when one alternative is chosen.
Sunk Cost - answerA cost that has already been incurred and cannot be recovered.
Step 1 - answerGroup production overheads into activities, according to how they are
driven.
Step 2 - answerIdentify cost drivers for each activity, i.e. what causes these activity
costs to be incurred.
Step 3 - answerCalculate an OAR for each activity.
Step 4 - answerAbsorb the activity costs into the product.
Step 5 - answerCalculate the full production cost per unit and/ or the profit or loss.
ABC Formula - answerTotal Activity cost/ Total number of units for activity
ABC - answerA costing method that assumes the steps or activities that must be
followed to manufacture a product are what determine the overheads incurred
Overheads used to be small - answerProduction overheads such as machine
depreciation, will have been a small proportion of overall costs. This is because
production was more labour intensive and, as a result, direct costs would have been
much higher than indirect costs. A rough estimate of the production overhead per unit
was therefore fine.
Overheads are now a larger proportion of total costs - answerManufacturing has
become more machine intensive and, as a result, the proportion of production
overheads, compared to direct costs, has increased. Therefore, it is important that an
accurate estimate is made of the production overhead per unit.
The nature of manufacturing has changed. - answerMany companies must now operate
in a highly competitive environment and, as a result, the diversity and complexity of
products has increased.
Differential Cost - answerThe difference between the cost of two alternative decisions,
or of a change in output levels. Example of alternative decisions. If you have to decide
between a cost of $1,200,000, and $1,400,000, then the differential cost between the
two alternatives is $200,000.
Opportunity Cost - answerThe cost of other alternatives when one alternative is chosen.
Sunk Cost - answerA cost that has already been incurred and cannot be recovered.
Step 1 - answerGroup production overheads into activities, according to how they are
driven.
Step 2 - answerIdentify cost drivers for each activity, i.e. what causes these activity
costs to be incurred.
Step 3 - answerCalculate an OAR for each activity.
Step 4 - answerAbsorb the activity costs into the product.
Step 5 - answerCalculate the full production cost per unit and/ or the profit or loss.
ABC Formula - answerTotal Activity cost/ Total number of units for activity
