Activity Based Costing

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ctivity-Based Costing (ABC) arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods which were designed around the late 1800s and early 1900s. Before the development of information technologies, it was labour intensive, product variety being small and the overhead costs in companies were generally very low compared to today. As we are in the era of Generation Y and beyond, this changes the traditional cost accounting methodologies. Will it be an asset or a liability? Has or will ABC overcome the deficiencies in traditional costing or not?

Understanding Traditional Costing

Many manufacturing companies use the traditional costing system to assign manufacturing overhead to units produced. Users of this type of costing method assumed that the volume is the driver of manufacturing overhead cost. In addition, accountants assign manufacturing costs only to products. Traditional accounting will not allocate non manufacturing costs that are also associated with the production of an item, such as administrative expenses.

Understanding ABC

It is constructed in a similar fashion to the traditional system but instead of having one predetermined overhead allocation rate, multiple rates are determined, one for each cost driver. In other words, a volume based driver such as direct labor hours is replaced by multiple drivers such as batch and customer based drivers which are not volume related.

In the 1980s, ABC had become increasingly important at the time it was introduced. When the firm overheads experienced an increase relative to the total cost, such organization was struggling with how to identify the value in overheads. There was little understanding as to how the overhead rates (such as indirect service) can be linked with the factory practices.

ABC only assigns a cost to a product if decisions concerning that product will cause changes in the cost. The five steps involved in ABC: identifying activities, determining...