Activity based cost accounting is also known as ABC or activity based costing. In ABC methodology, the costs are allocated to the products and the services which are based on the transactions/events number which are involved in the process of product/service providing. ABC was developed in the manufacturing sector of the United States during 1970 – 80. Robert Kaplan and Robin Cooper gave it a broader audience. This cost accounting method is used to match the costs with the activities which cause those costs, also known as cost drivers. It replaces labor based costing system and is most sophisticated type of absorption – costing. In ABC accounting, those items are allocated overheard which actually use it. In the complex environments, it works the best. But there are many tangled processes, machines, equipments and products which can’t be sorted out easily. In the streamlined environment, where the product processes are abbreviated, ABC is less in use.
Activity based costing is a technique which is used for cost allocation to a customer, product or service. Here, the activities cause cost to the organization. So, the cost of the activities is identified and all the activities’ costs have been determined. After it, the cost of activities is allocated to the products, services or the customers that required the activity. Activity based costing is relatively more logical to allocate the overhead than the simply allocating costs which are based on the machines hours or for the labor cost directly. A very effective management approach, ABC is used to distribute and control the overhead costs. With help of ACB methods, the overhead analysis can be made more accurate. ABC is used for a variety of products such as for product costing and profitability analysis and for the distribution and control of the overheads appropriately.
With help of ABC, the company can easily estimate the cost elements of the entire services, activities and the products. This can help the company to make decision to either to identity and eliminate the unprofitable and lower prices products and services which are overpriced. It also helps to identify and eliminate the production or service process which are not effective and allocate processing concepts. These concepts lead to the very same products same product at better yield (process re – engineering aim). Activity based costing identifies a relationship between the products, activities and costs. Through this relationship, it assigns the indirect costs to products less arbitrarily than the traditional methods. Management and office staff salaries are some indirect costs which are difficult to assign to a particular product produced. In order to support the annual budgets and determine the customer profitability, activity based costing can provide detailed cost information. It can also enable the management to check if the performance can be maximized and growth strategies realized. ABC is a modeling process. It is applicable for full scope as well as for the partial views. It can further help to identify the insufficient products, departments and activities. Activity based costing involves following steps:
- It includes the identification of the activities which are involved in the production process.
- It includes the classification of each activity according to the cost hierarchy which means into the unit – level, batch – level, product level and facility level.
- It involves the identification and accumulation of the total costs of each of the activities involved.
- Reorganization of the most appropriate cost driver used for every activity.
- Calculation of the total units of the cost diver which are relevant to each of the activities.
- Calculation of the activity rate which means the cost of each of the activity per unit of the relevant cost driver.
- Application of the cost of each of the activities to the products based on the activity usage by the products.
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