Economic

Activity Based Costing (ABC)

The emergence of ABC systems

During the 1980s the limitations of traditional product costing systems began to be widely publicised. These systems were designed decades ago when most companies manufactured a narrow range of products, and direct labour and materials were the dominant factory costs. Overhead costs were relatively small, and the distortions arising from inappropriate overhead allocations were not significant. Information processing costs were high, and it was therefore difficult to justify more sophisticated overhead allocation methods.

Today companies produce a wide range of products; direct labour represents only a small fraction of total costs, and overhead costs are of considerable importance. Simplistic overhead allocations using a declining direct labour base cannot be justified, particularly when information processing costs are no longer a barrier to introducing more sophisticated cost systems. Furthermore, the intense global competition of the 1980s has made decision errors due to poor cost information more probable and more costly. Over the years the increased opportunity cost of having poor cost information, and the decreased cost of operating more sophisticated cost systems, increased the demand for more accurate product costs. It is against this background that ABC has emerged. ABC, however, is nor a recent innovation. Fifty years ago Goetz (1949) advocated ABC principles.

The main steps are

Step 1: Identify the chosen Cost Objects ( product, service or customer )

Step 2: Identify the Direct Costs i.e. Prime cost of the Products, service or customer

Step 3: Select the Activity Bases.

Step 4: Identify the costs associated with each Activity. Apply Allocation & Apportion Technique

Step 5: Compute the Rate per cost driver.

Step 6: Compute the Indirect Costs of the Products = activity for the product ( rate per driver....