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# ACTIVITY BASED COSTING It is an accounting method that identifies the activities that a firm performs, and then assigns

indirect costs to products. An activity based costing (ABC) system recognizes the relationship between costs, activities and products, and through this relationship assigns indirect costs to products less arbitrarily than traditional methods. STEP IN ACTIVITY BASED COSTING The following are the steps in activity based cost allocation: 1. Identification of the main activities: First of all, major activities in the organization are identified. The number of activities in an organization should neither be too large nor too small. Too large a number will be costly and will add to the complexity of the system white a too small number of activities will compromise with the accuracy of the cost. Total cost involved in the activity should be significant enough to justify to give an activity a separate treatment. 2. Creation of cost pool: Cost pool is grouping of individual cost items. A cost pool or cost bucket should be created for each activity. Cost pool is like a cost centre around which costs are accumulated. For example, the total cost of machine set ups might constitute one cost pool for all set up related costs. 3. Determination of the activity cost drivers: The factors that influence the cost of a particular activity is known as cost drivers. In other words, cost drivers signify the factors or events that determine the cost of activity. Example of cost drivers as given above are number of machine set ups, number of purchase orders, number of customer orders placed, etc. 4. Calculation of the activity cost driver rate: Just as an overhead absorption rate is calculated in traditional costing system. In ABC a cost driver rate is calculated as follows: Total cost of activity Activity cost driver rate = _________________ Cost drivers Changing the cost of activities to products: The cost of activities are traced to products on the basis of demand by products. The cost drivers are used to

measure product demand of activities. For example, the total cost allocated to cost centre for machine set up related costs is Rs. 50,000 and that there were 100 set ups during the periods. Thus the rate per set up is Rs 50,000 / 100 = Rs 500. If a particular product needs 10 set ups, charge to that product will be Rs 500 x 10 = Rs 5,000. If 20 units of the products are produced, cost per unit will be Rs 5,000 / 20 units = Rs 250. In this way, cost of other activities also will be charged to product. Advantages of ABC Among the major benefits of activity-based costing that many firms have Experienced are: Better profitability measures. ABC provides more accurate and informative product costs, leading to more accurate product and customer profitability measurements and to better-informed strategic decisions about pricing, product lines, and market segments. Better decision making. ABC provides more accurate measurements of activity-driving costs, helping managers to improve product and process value by making better product design decisions, better customer support decisions, and fostering value enhancement projects. Process improvement. The ABC system provides the information to identify areas where process improvement is needed. Cost estimation. Improved product costs lead to better estimates of job costs for pricing decisions, budgeting, and planning. Cost of unused capacity. Since many firms have seasonal and cyclical fl uctuations in sales and production, there are times when plant capacity is unused. This can mean that costs are incurred at the batch-, product-, and facility-level activities but are not used . Capacity is supplied but not used in production. ABC systems provide better information to identify the cost of unused capacity and maintain a separate accounting for this cost. Limitations or disadvantages of ABC Although activity-based costing provides better product or service costs than volume based systems, managers should be aware of its limitations:

Allocations. Not all costs have appropriate or unambiguous activity or resource consumption cost drivers. Some costs require allocations to departments and products based on arbitrary volume measures because fi nding the activity that causes the cost is impractical. Examples are facility-sustaining costs such as the costs of the information system, factory managers salary, factory insurance, and property taxes for the factory. Omission of costs. Product or service costs identified by an ABC system are likely to not include all costs associated with the product or service. Product or service costs typically do not include costs for such activities as marketing, advertising, research and development, and product engineering even though some of these costs can be traced to individual products or services. Product costs do not include these costs because generally accepted accounting principles (GAAP) for financial reporting require them to be treated as period costs. Expense and time. An ABC system is not cost free and is timeconsuming to develop and implement. For fi rms or organizations that have been using a traditional volume-based costing system, installing a new ABC system is likely to be very expensive. Furthermore, like most innovative management or accounting systems, ABC usually requires a year or longer for successful development and implementation.