Chapter2ActivityBasedCosting.docVIP

Chapter 2 Activity Based Costing 1. Objectives 1.1 Explain the ABC concept and the reasons for development of ABC. 1.2 Identify appropriate cost drivers under ABC. 1.3 Calculate costs per driver and per unit using ABC. 1.4 Compare ABC and traditional methods of overhead absorption based on production units, labour hours or machine hours. 1.5 Explain when to use ABC is more appropriate. 1.6 Explain how ABC can assist the decision making for management. 1.7 Describe the advantages and disadvantages of ABC. 2. Introduction to ABC 2.1 Activity Based Costing (a) Activity based costing (ABC) is a form of absorption costing. However, it differs from traditional absorption costing, because it takes a different approach to the apportionment and absorption of production overhead costs. (b) ABC involves the identification of the factors (cost drivers) which cause the costs of an organization’s major activities. Support overheads are charged to products on the basis of their usage of an activity. (i) For costs that vary with production level in the short term, the cost driver will be volume related (labour or machine hours). (ii) Overheads that vary with some other activity (and not volume of production) should be traced to products using transaction-based cost drivers such as production runs or number of orders received. 2.2 Reasons for the development of ABC 2.2.1 In recent years, there has been dramatic fall in the costs of processing information. And, with the advent of advanced manufacturing technology (AMT), overheads are likely to be far more important and in fact direct labour may account for as little as 5% of a product’s cost. It therefore now appears difficult to justify the use of direct labour or direct material as the basis fro absorbing overheads or to believe that errors made in attributing overheads will not be significant. 2.2.2 Many resources are used in non-volume related support activities, such as setting-up, production scheduling, inspection and data