Activity Based Costing which is popularly known as ABC system has been considered as “ an economic map of an organisation ‘s disbursals and profitableness based on organisational activities ” harmonizing to Kaplan R ; and Cooper R.

“ An activity is an event, undertaking or unit of work with a specified intent, for case, planing a merchandise, puting up machines, runing machines, and distributing merchandises ; ” by Horngren, Foster, Datar. Harmonizing to Kaplan R.S & A ; Cooper R ; ABC system came in the mid-1980s to run into the demand for accurate information required by directors about cost of resources demanded by single merchandises, services and clients. It emerged as competition moved from local to planetary and from the efficient usage of direct labor and machines.

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Absorption Costing besides known as full costing is a traditional costing system developed in the 1900s, by which operating expenses incurred within a period were absorbed into the merchandises by Kilgour D. The traditional soaking up costing was introduced at a clip when engineering was simpler, competition was local, merchandises were standard and non customised merchandises and services, velocity, quality and public presentation were non measurement for success in mention to Kaplan R.S & A ; Cooper R.

Importance of Absorption Costing System or Activity Based Costing:

Harmonizing to Horngren, Foster & A ; Datar, the importance of a costing system should depend on whether the company is bring forthing one type of merchandise and hence could apportion all operating expense costs utilizing one cost pool and one cost rate or whether the company is bring forthing different sort of merchandises and hence necessitate a system which could enable it apportion the entire cost of resources accurately harmonizing to their use of those resources. As companies began to spread out and dig into bring forthing assortment of merchandises, they began to detect that some merchandises place more demand on their resources than others.

It became of import to absorb overhead when merchandises which are non the same but needed different production processes or occupations which although the usage the same installation but at a length of clip harmonizing to Terry L. To determine how to allocate operating expenses to merchandises or services, traditional soaking up bing involves two phases ; the first phase is the allotment and allotment and the 2nd phase is the usage of soaking up rate to absorb operating expenses into merchandises.

Overhead Allotment: Terry L ; overhead allotment is the assignment of all cost incurred to a individual cost unit, centre history or clip period.

Overhead Allotment: This is a instance where the costs incurred could non be identified with merely one cost Centre therefore the cost is shared between the cost Centres utilizing that service, for case, illuming cost would be shared between all the cost Centres utilizing a suited footing, Terry L. It is of import that the footing upon which costs are apportioned are relevant, just and just ; Terry L.

Overhead Absorption Rate: This is normally calculated at the beginning of a period therefore it is based on budgeted costs and production volumes, AAT units 8 & A ; 9. The expression is as follows: Entire operating expenses of cost Centre

Entire figure of units of soaking up base applicable to be Centre

Harmonizing to Terry L ; before ciphering soaking up rate, the soaking up base chosen has to reflect the features of the given cost Centre. The footing most normally used are direct labour hours for a labour intensive cost Centre and the machine hr footing normally used where the cost Centre is extremely mechanised. With exclusion of the above two footing, other footing include ; Direct rewards, Direct stuff, Prime cost and Cost unit.

ABC System: Activity Based Costing began in a fabrication scene but has been more service -oriented than merchandise oriented. Service Industries every bit much as fabrication industries need ABC system to link the cost resources they supply to the grosss earned by the single merchandises and clients serviced by these resources in mention to Horngren, Foster & A ; Datar.

ABC System has three key characteristics are: ( 1 ) With the system all costs used by a merchandise whether variable or fixed in the short-run or operating expenses ( indirect costs ) in the long-run are identified by making cost pools as ABC is focused on long-term variable costs for case as Terry L ; said, “ costs for back uping activities like stock handling, production programming and so on ” .

Cost Pool: Classifying all related costs to a peculiar activity together harmonizing to Terry L.

( 2 ) The 2nd characteristic of ABC system is ; An sum of an activity performed in each cost pool is recognised as a footing of allotment for case, set-up hours as a step of set up activity. Horngren, Foster, & A ; Datar.

( 3 ) The 3rd characteristic is that costs in a cost pool can sometimes be traced straight to merchandises. Horngren, Foster, & A ; Datar.

The Differences Between Traditional Absorption Costing and Activity Based Costing.

The differences between the two costing system are easy to detect. Below are lists of some of them:

The traditional soaking up costing was introduced at the clip when engineering was simple, there was merely local competition and non planetary, when merchandises were standard non customised, from Kaplan S.R & A ; Cooper R.

ABC system emerged at the clip when competition had become planetary and ferocious and had shifted from the efficient usage of labor hours and machines, by Kaplan S.R & A ; Cooper R.

The traditional costing uses largely two allotment bases to apportion operating expenses to merchandises ; direct labour footing for a labour intensive company and the machine hr footing for a extremely mechanised company. These two bases would non capture the demand of a peculiar merchandise on the resources of the administration. There are no cause and consequence relationship to an allotment base with the usage of this method, Horngren, Foster, & A ; Datar.

With ABC system, costs of activities within the administration are more accurately measured because the cost pools are decently structured with specific activity cost allotment bases which became cost drivers for the cost pool. Cost Driver: “ factor act uponing the degree of cost ” from Terry L.

In the traditional soaking up system, soaking up rates are based on preset figures thereby giving rise to under and over soaking up of operating expense. Under soaking up arises when the estimated operating expense is less than the existent operating expense. Over soaking up of overhead arises when the operating expense absorbed exceeds the existent operating expense ; from AAT Study text units 8 & A ; 9.

The measuring required to implement ABC system are dearly-won as the system demands that direction should gauge costs of activity pool, identify and step cost drivers for the cost pools to function as allotment bases ; from, Horngren, Foster, & A ; Datar.

The usage of ABC system will necessitate its activity cost rates to be updated on a regular basis and a elaborate ABC system consumes clip, is hard to understand and run, Horngren, Foster & A ; Datar.

Illustration: “ As an illustration of the differences between traditional soaking up costing and activity based costing, with attending to put up activity, the consequence of apportioning all operating expenses utilizing direct labor hours as against an ABC accent on single activities, the name of the company shall be called Z. Z produces two sorts of lenses for an car company. The first merchandise is a simple lenses, the 2nd merchandise is called complex lenses. ”

“ Set ups involves test tallies, all right tuning, accommodations, incorrect set-ups cause quality jobs such as abrasions. Each set-up requires different resources depending on the complexness of the operation. Complex lenses are produced in little batches because the cast has to be cleaned more frequently. ” Horngren, Foster & A ; Datar.

Harmonizing to Horngren, Foster, & A ; Datar, set-up informations for simple lens and complex lens are:

Simple Complex

S3 lens CL5 lens Entire

( 1 ) Measure produced 60,000 15,000

( 2 ) Lens per batch 240 50

( 3 ) No of batches ( 1/2 ) 250 300

( 4 ) Set-up clip per batch 2hours 5hours

( 5 ) Entire set-up hours ( 3 ) * ( 4 ) 500hours 1500hours 2000hours

Direct fabricating labor hours 30000hrs 9750hrs 39750hrs

Z recognises entire cost of set-ups comprising of allocated costs of procedure applied scientists, supervisors, set-up equipment of ?300,000.

Solution: The tabular array below shows how the set-up costs have been allocated to simple and complex lenses utilizing direct labor hours and setup hours:

Setup cost per direct labor hours:

( 300,000/39750 ) =?7.54717

Setup cost per apparatus hours:

( 300,000/2000 ) = ?150

Simple Complex Total

S3 lens CL5 lens

Cost allocated utilizing direct labour hour:

?7.54717* 30000 ; ?7.54717*9750 ?226,415 ?73,585 ?300,000

Cost allocated utilizing apparatus hour:

?150*500 ; ?150*1500 ?75,000 ?225,000 ?300,000

Implementing the Activity Based Costing System:

The pick of implementing Activity Based Costing depends on the directors after measuring the advantages and disadvantages, commanding the sum of inside informations required and cost.

ABC system enables direction to see their bing and predetermined cost of activities and concern procedures which so equips them with cognition of the cost and profitableness of the assorted merchandises, services, clients and runing units harmonizing to Kaplan S.R, & A ; Cooper R. There are several stairss the company could take to alter the bing costing system. These are:

Measure 1: List all the activities of the company performed by indirect and support

Resources, for case, stuff handling, agenda production and so on.

Measure 2: Find out how much the company is passing on each activity in the company.

Step3: Indentify the company ‘s merchandises, services and clients, Kaplan S.R, Cooper R.

Step4: Charge support operating expenses by their use of the activity with accent on the

Cause-effect relationship.

Recommendation: ABC system is recommended since it provides more accurate merchandise

Costss. The system has been used successfully in some service industries

Such as the Concerted Banks to place profitableness, merchandise mixes,

Improve efficiency and satisfy clients, Horngren, Foster & A ; Datar.


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