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Alternative costing method - Coggle Diagram
Alternative costing method
Activities-based costing (driving overhead)
Definition
is a method costing
which is involves identifying the costs of the main supporting activities
and the factors that drive the costs of each activity
Support overheads are charged to products by absorption cost on the basis of product's usage of the factor driving the overheads
Major ideas
Activities cause costs: ordering, materials handling, machining, assembly, production scheduling and despatching
Manufacturing products creates demand for support activities
understand easily
Costs are assigned to a product on the basis of the product's consumption of these activities
Cost driver is a factor which has the most of influence on the cost of an activity
to calculate ABC
Step 1: Identify organisation's activities causing costs
Step 2: Identify cost pools
Step 3: Identify cost driver
Step 4: Calculate Absorption rate per cost driver
Step 5: Charge overhead costs to products for each activities
Reasons for development of ABC
Absorption costing was developed in time
most of manufacturers produced only a narrow range of product
Products underwent similar operations and consumed similar proportion
Overhead cost were only a very small fraction of total production costs
Traditional absorption costing system allocate
too great a proportion of overhead to high volume product
too small a proportion of overhead to low volume product
Activities-based costing attempt to overcome above problem
with the dramatic fall in the costs of processing information
with the advent of advanced manufacturing technology (AMT)
Overhead costs have become a much larger proportion of total production costs, and direct labour has become much less important
it is therefore now difficult to justify the use of direct labour hour as the basis for absorption overheads, to produce realistic product cost
with the falling costs of information processing
have made it possible to switch to a different and more complex system for accumulating and analysing overhead cost
ABC may now be cost-effective whereas in the past its high costs could have made it difficult to justify
Many resource are used in non-volume related support activities, which have increased due to AMT
In general, affected by changes in production
These support activities assist the efficient manufacture of wide range of production and are not
Merits of ABC
The complexity of manufacturing has increased, ABC recognises this complexity with its multiple cost drivers
ABC facilitates a good understanding of what drives overhead costs
ABC is concerned with all overhead costs
ABC can assist with decision making in a number of ways
to be provide accurate and reliable information
to establish a long-run product cost
to provide cost data which may be used to evaluate different ways of delivering business
it is particularly suited to following types of decision
Promoting or discontinuing products or parts of the business - ABC may help identify activities costs that may be either incurred or saved
Developing new products or new ways to do business, because ABC focused on the support activities that would be required for new product or business procedure
Pricing where selling price are derived by adding a profit mark-up to cost
Criticisms of ABC
The cost of implementing and maintaining can excess the benefits of improved accuracy in production costs.
Implementing ABC is often problematic, due to the problem with understanding activities and their costs
Management is not going to use ABC information for any practical purposes, a traditional absorption costing system would be simpler to operate.
A single cost driver may not explain the cost behaviour of all items in a cost pool
Unless cost are driven by activities that is measurable in quantitative terms, cost driver cannot used.
Cost apportionment may still be required at the cost pooling stage for shared items of cost such as rent, rates and building depreciation. Apportionment can be an arbitrary way of sharing cost.
ABC is an absorption costing system. Absorption costing has only limited value for management accounting purposes
When ABC should be used
when production overheads are high relative to prime costs
when there is a whole diversity of product range
when there are considerable differences in the use of resources by product (more activities)
when consumption of resource is not driven by volume
Arguments for ABC
Accurate cost calculation (fair distribution of Overheads)
Accurate selling price (better costing information)
Better cost control
Better decision making for the continuation/discontinuation of production if losses
Better planning - activity based budgeting
Better performance measurement
Arguments against for ABC
ABC is time consuming and expensive.
Many judgmental decisions still required in the construction of an ABC system
Selection of cost driver may not be easy. A single cost driver may not explain the behavior of all items in a cost pool. There may be more than one cost drivers for an activity
The cost implementing and maintaining an ABC system can exceed the benefits of improved accuracy in product costs. ABC will be of limited benefit if overhead costs are primarily related
Reduced benefit if the company is producing only one product or a range of products with similar costs
Some arbitrary apportionment may still exist.
There must be a reason for using a system of ABC. ABC must provide meaningful product costs or extra information that management will use. If management is not going to use ABC information for any practical purpose, a traditional absorption costing system would be simpler to operate and just as good