CAT T7,ACCA F5-Activity based costing

I know not everyone know about this costing technique as it was relatively unknown and not commonly used,most people prefer absorption costing(AC),marginal costing(MC) and standard costing.Therefore not many people really know how to use activity based costing(ABC).I am here to provide guideline in how to use ABC to calculate the cost of products.

The traditional approach to fixed overhead absorption has the merit of being simple to calculate and apply. However, simplicity does not justify the production and use of information that might be wrong or misleading.For example,in absorption costing,when we use labour hour as the base to have an overhead absorption rate(OAR),it is not accurate if we have different types of overhead which didn't use any labour hour,thereby causing the final cost per unit of product charged is misleading.In the modern manufacturing environment now,overheads are much greater in proportion of total costs and direct costs are lower because human is replaced by technology.Therefore traditional costing technique cannot provide an accurate cost information.

ABC is a costing model that identifies activities in an organisation and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect costs(overheads) into direct costs.Simple speaking,ABC analyses the cost according to the cost driver.Cost driver is factor which causes a cost of an activity(cost pool),it might be better to think of it as the ‘cost causer’.For example,the cost driver of the material handling costs would be number of components handled.Ok let's get started,the steps of ABC is as follow:
1.Identify a cost
2.Identify cost driver
3.Calculate cost driver rate(cost incurred each time the activity occurs.)
4.Trace the cost into the units produced

A simple example would enhance understanding:Cost of goods inwards department totalled $10000.During 2010 there were 1000 deliveries.200 of these deliveries related to product X.2000 units of product X were produced.Calculate the unit cost of product X.
1.We know that the total cost of good inwards is $10000.
2.We then identify the cost driver,in this case the cost driver is the number of deliveries and we have total of 1000 deliveries in this year.
3.Then you find out the cost driver rate(this is just like OAR but we calculate according to each activity),cost driver rate=total cost/cost driver=$10000/1000=$10.
4.Then use this $10 to charge against the total deliveries for product X,in this example there are 200 deliveries for product X,therefore $10 X 200=$2000,this cost is the total cost of 2000 units product X,we want to find unit cost,therefore
unit cost=cost/units=$2000/2000units=$1.

Therefore in this example,if there is other product,for example 500 deliveries for 500 units of product Y,then take the cost driver rate of $10 multiply with 500 deliveries=$5000,$5000 is the total cost for 500 deliveries,so unit cost=$5000/500units=$10.

I hope this simple example helps to understand how to calculate costs using ABC,there may be more activity such as material handling costs,set-up costs and so on given in exam or in reality,you need to identify cost driver for each activity and get a cost driver rate for each activities,then find out the costs by multiplying the activities consumed by each products and finally adding all costs up to get the final total costs for each products.

In addition to estimating more accurately the true cost of production,ABC will also give a better indication of where cost savings can be made.Working on the principle that large cost savings are likely to be found in large cost elements,management's attention will start to focus on how this cost could be reduced.But ABC has limitations as well,it undoubtedly requires an organisation to spend time and effort investigating more fully what causes it to incur costs,and then to use that detailed information for costing purposes.It can be very complex,recently there are only about 4% of companies in this world which actually implemented ABC.But understanding the drivers of costs must be an essential part of good performance management.

In summary,ABC can be used to identify inefficient products, departments and activities,allocate more resources on profitable products, departments and activities,control the costs at an individual level and on a departmental level,find unnecessary costs and helps in fixing price of product or service scientifically.It is very hard to implement in practice although it provides accurate information,practice often if you are interested to try to implement ABC in your business or workplace,make sure you understand everything about ABC.You should also understand that ABC values inventory using full production cost(variable production cost+fixed production overheads),therefore it is similar to AC in this way.

The most important thing to remember in the calculation of cost using ABC is the 4 steps,if you follow the steps,it will definitely help you a lot and you can do most questions.Practice for a number of times until you are used to the steps.