In traditional approach, the exact cost of products or services is probably impossible to determine. The use of direct labor as the activity base made sense when overhead cost allocation systems were first developed. At that time direct labor made up a large portion of total manufacturing cost. Therefore, it was widely accepted that there was a high correlation between direct labor and the incurrence of overhead cost. As a result, direct labor became the most popular basis for allocating overhead. Traditional cost models apply resources to products in two ways.
So called direct costs like material and direct labor are attributed directly to the product and other resources are arbitrarily allocated to the product, typically through the mechanism of direct labor hours, labor dollars or machine hours. Sales, marketing and administrative costs are not included in product costs Nowadays many manufacturers and service company find it inappropriate to use direct labor for overhead costing. This is because, a lot of companies now ABC) is a method of allocating costs to products and services.
It is generally used as a tool for planning and are using computerized system, technological innovation, global competition, and automation. Thus, the size of direct labor used in the production process is decreasing. As a result depreciation on expensive equipment and machinery, utilities, repairs, and maintenance of total overhead cost increase. Many companies take solution by using the machine hours as the basis to allocate the overhead. But even that couldn’t solve the case if manufacturing process is complex. So the most effective method to use is the activity base costing.
Management accountant overcome this problem by using activity based costing (ABC) Activity-Based Costing (control. It was developed as an approach to address problems associated with traditional cost management systems, that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. With these defiencies managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services.
ABC allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods. The activities responsible for the costs can be identified and passed on to users only when the product or service uses the activity. Some of the advantages ABC offers is an improved means of identifying high overhead costs per unit and finding ways to reduce the costs. The primary task of activity based costing is to break out indirect activities into meaningful pools which can then be assigned to processes in a manner which better reflects the way costs are actually incurred.
The system must recognize that resources are consumed by processes or products in different proportions for each activity. With ABC, all costs reside in resources, which are such things as material, labor, space, equipment and services. Resources are consumed by activities which have no inherent cost. The cost associated with activities represents the amount of resource they consume per unit of activity. Resources and activities are then applied to cost objects, that is, the purpose for which the resource is consumed and the activity is performed.
Each resource and activity has a unit of measure which defines the amount of the resource consumed or activity required by a unit of demand for it. Resources can be consumed by resources (e. g. office space resource is consumed by an employee resource), by activities (e. g. telephone resource is consumed by a customer service call activity) or by cost objects (e. g. material resource is consumed by a product cost object). Activities can be performed in support of another activity (e. g. nvoice printing activity supports the billing activity) or in response to a cost object (e. g. purchase orders are issued to support the material acquisition process). A cost object can be a process or product and either an interim cost object or an end user (customer) cost object. For example, hiring personnel may be a cost object of Human Resources Department utilizing space, utility, telephone, supply and labor resources and performing advertising, calling, interviewing and orientation activities.
That cost object may be a resource used by other departments to secure labor resource for their department. Building a network of resources, activities and cost objects defines the operational flow of the process or processes to be costed. Each resource and activity has a unit of measure which converts them at a unit of demand rate. If a cost model is to be useful and effective in determining process and product costs, it is imperative that the business process be identified and understood first. Only then can costs be attached to determine the cost of the defined process.
Activity-based costing is a more accurate cost management system than traditional costing. Activity based costing create more cost pool, being use to assign overhead cost to products. Instead of one plantwide pool and a single cost driver, company uses numerous activity pools with more relevant cost drivers. Cost are assigned more directly on the basis of cost drivers used to produce each product. Enhance control over overhead cost, under ABC, company can trace many overhead cost directly to activities, allowing some indirect cost to be identified as direct cost.
Thus manager have become more aware of their responsibility to control the activities that generates those costs. Activity base costing help management to decide wisely because of more accurate product costing should contribute to setting selling price that can help achieve desired product profitability level. In addition, more accurate cost data could be helpful in deciding whether to make or buy a product part of component, and sometimes even whether to eliminate a product.