Activity based costing (ABC) systems look at the underlying activities that driv

Question

Activity based costing (ABC) systems look at the underlying activities that drive costs within organizations and use these to assign costs. The use of ABC in organizations presents a unique way to reduce overall costs and better track the costs that arise within the overall process. Consider these problems related to cost accounting and in a 1-2 page Word document, address the following points. Be sure to proofread your work prior to submitting to the drop box. Describe the three guidelines for costing system refinement. Explain what an activity based approach to designing a costing system would entail and contain. Describe the four levels of cost hierarchy. Why is it important to classify costs into each of the hierarchies? Explain the main costs and limits to implementing ABC systems. Why might management worry about over costing or under costing products? What would be the impact to the overall organization if this occurs?

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Explanation / Answer

Solution:

Three guidelines for costing system refinement are – direct cost tracing, indirect cost pools and cost allocation basis. The objective of direct cost tracing is to identify the cost which are directly associated with a particular product or processes. Indirect cost pools collect those cost which cannot be directly allocated to any particular product or process. The third guideline i.e. cost allocation basis identify the cost drivers for each category cost pools so that it can be used as a basis for allocating the common cost.

Activity based costing is an alternative method of overhead allocation. Traditional absorption costing method which is widely used to allocated overhead has large number of loop holes in the present production systems where large number of goods are produced by the organization and labour cost which is primarily used to allocate the overhead constitute only a small portion of the total cost. Thus in order to overcome such problems a new technique was propounded by Goetz in the year 1949.

The primary steps involved in the activity based costing are as under –

Step 1: The very first step involved in this is the identification of Cost Objects (product, customer or service)

Step 2: Identify the direct cost which are associated with the Products, service or customer

Step 3: The next step involved is the Activity Bases.   

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

Step 5: Rate per cost driver is to be computed on the basis of cost allocated

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

Step7: Compute the Total Costs of the Products = Direct costs + Indirect Costs.

Some of the benefits of activity based costing techniques are as under –

ABC systems helps the management in highlighting the problems which arise in various activity areas this helps the management to overcome such problems and helps in reducing the problems

The four levels of cost hierarchy are – Direct cost, Cost object, Cost allocation base and Indirect cost pool. It is important to classify the cost into all these four hierarchy as certain cost can be identified exclusively to a particular job and hence it cannot be put into the common cost pool.

Under or over absorption of overhead does not affect the overall performance of the company. However, it may affect the performance of a particular segment in the company. Management may worry about over or under absorption because under absorption of overhead means that the cost has not been charged to the customer thereby reducing the actual margin of the company.

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