F5
| Advanced Costing systems |
1. Activity Based Costing
Inadequacies of absorption costing
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Implies all overheads are related to production volume
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Tends to allocate too great a proportion of overheads to larger products
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Could lead to over production (in order to show increased profit)
Outline of an ABC system
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Identify major activities
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Identify cost drivers – factors which determine the size of an activity/cause the costs of an
activity
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Collect costs associated with each activity into cost pools
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Charge costs to products on the basis of the number of an activity's cost driver they generate
Prepared By: Muhammad Irfan
1
F5
| Advanced Costing systems |
Steps in ABC
1. Group overheads into activities
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Cost pools
2. Identify significant factors driving the costs
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Cost drivers
3. Calculate a cost per unit of cost driver
4. Absorb activity costs based on usage of drivers
Cost drivers
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Volume related (eg labour hrs) for costs that vary with production volume in the short term (eg
power costs)
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Transactions in support departments for other costs (eg number of production runs for the cost
of setting up production runs)
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Absorption costing uses one universal OAR based on machine/labour hours
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Implication that overheads are volume related
Prepared By: Muhammad Irfan
2
F5
| Advanced Costing systems |
Merits of ABC
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Simple once information obtained
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Focuses attention on what causes costs to increase (cost drivers)
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Absorption rates more closely linked to causes of overheads because many cost drivers are used
Better analysis of costs leads to better:
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Cost control
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Production decisions
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Pricing decisions
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Profitability analysis
Criticisms of ABC
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More complex and so should only be introduced if provides additional information
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Can one cost driver explain the behaviour of all items in a cost pool?
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Cost drivers might be difficult to identify
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Time consuming
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Costly
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Some arbitrary apportionment may still exist
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Limited benefit if products have similar cost structures
Exam Focus.
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Questions will require you to identify an appropriate driver to use when calculating costs per
unit using ABC.
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Calculation of OARs and then cost per unit using ABC will be required.
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Identifying the differences between absorption and ABC may be required in section A and
section B questions.
Prepared By: Muhammad Irfan
3