Page 1 - ABC Notes

Activity Based Costing

Activity Based Costing ABC

Introduction

Traditionally all overheads were absorbed on production volume (measured as labour
or machine hours) even though many support overheads vary, not with production
volume, but with the range and complexity of production. When support overheads
were only a small proportion of total costs the methods of absorption used probably
did not matter too much.

Today however the position is dramatically different. Direct costs are a declining
proportion of total costs and support overheads relating to such things as technical
engineering and design services, planning, tooling, data processing, etc are a major
proportion of costs in many modern factories. It is therefore of considerable
importance that support overheads are traced to product costs in a more realistic
manner.

This is done by collecting overheads into cost pools and using cost drivers to charge
the product with a suitable amount of overheads to reflect its usage of the particular
support overhead.

Implementing and activity based costing system (ABC)

The primary objective of ABC is to provide more accurate costing of products and
services to assist managers make better decisions. Its basic principle resided in the
assumption that overheads are caused by activities - the more an activity is repeated,
the greater the amount of overhead incurred. In order to properly link overheads to
products it is important to understand what created the cost and then to assign the
overheads according to the relationship between the product and the activity that gave
rise to the overhead. This effectively means that the product that uses more of the
activity will bear a greater proportion of that particular overhead.

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