Activity Based Costing – Definition and Concept Essay

July 26, 2017 Accounting

An attack to the costing and monitoring of activities which involves following resource ingestion and bing concluding end products. Resources are assigned to activities. and activities to be objects based on ingestion estimations. The latter utilise cost drivers to attach activity costs to end products. ’ Activity-based costing ( ABC ) is a bing methodological analysis that identifies activities in an organisation and delegate the cost of each activity with resources to all merchandises and services harmonizing to the existent ingestion by each. This theoretical account assigns more indirect costs ( overhead ) into direct costs compared to conventional costing. CIMA Official Terminology. 2005

A development of the rules of activity based costing ( ABC ) is activity based direction ( ABM ) . Operational ABM is defined as:

‘Actions. based on activity driver analysis. that addition efficiency. lower costs and/or better plus use. ’ CIMA Official Terminology. 2005 Strategic ABM is defined as: ‘Actions. based on activity based cost analysis. that aim to alter the demand for activities so as to better profitableness. ’ CIMA Official Terminology. 2005 The chief focal point of this subject gateway is ABC. However. the development of ABC into ABM will be discussed farther under Application. The construct of ABC was foremost defined in the late eightiess by Robert Kaplan and William Burns. Initially ABC focused on fabrication industry where technological developments and productiveness betterments had reduced the proportion of direct labor and stuff costs. but increased the proportion of indirect or overhead costs.

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Comparison of traditional costing and ABC

The traditional method of bing relied on the arbitrary add-on of a proportion of overhead costs on to direct costs to achieve a entire merchandise cost. The traditional attack to be allotment relies on three basic stairss. 1. Accumulate costs within a production or non-production section. 2. Allocate non-production costs to production sections. 3. Allocate the ensuing production section costs to assorted merchandises. services or clients. This type of bing system normally allocates costs based on a individual volume step. such as direct labor hours or machine hours.

While utilizing such a simplistic volume step to apportion operating expenses as an overall cost driver. this attack rarely meets the cause-and-effect standards desired in accurate cost allotment. This method of costing has become increasing inaccurate as the comparative proportion of operating expense costs has risen. This deformation of costs can ensue in inappropriate determination devising. ABC is hence an alternate attack to the traditional method or arbitrary allotment of operating expenses to merchandise. services and clients. AIM of the theoretical account

With ABC. an organisation can soundly gauge the cost elements of full merchandises and services. That may assist inform a company’s determination to either: * Identify and extinguish those merchandises and services that are unprofitable and lower the monetary values of those that are overpriced ( merchandise and service portfolio purpose ) * Or place and extinguish production or service procedures that are uneffective and allocate processing constructs that lead to the really same merchandise at a better output ( process re-engineering purpose ) . In a concern organisation. the ABC methodological analysis assigns an organization’s resource costs through activities to the merchandises andservices provided to its clients. ABC is by and large used as a tool for understanding merchandise and client cost and profitableness based on the production or acting procedures. As such. ABC has preponderantly been used to back up strategic determinations such as pricing. outsourcing. designation and measuring of procedure betterment enterprises.


In contrast to traditional cost accounting systems. ABC systems foremost accumulate operating expenses for each organizational activity. They so assign the costs of these activities to merchandises. services or clients ( referred to as cost objects ) doing that activity. The initial activity analysis is clearly the most hard facet of ABC. Activity analysis is the procedure of placing appropriate end product steps of activities and resources ( cost drivers ) and their effects on the costs of doing a merchandise or supplying a service.

ABC systems have the flexibleness to supply particular studies so that direction can take determinations about the costs of planing. merchandising and presenting a merchandise or service. The cardinal facet is that ABC focuses on roll uping costs via activities. whereas traditional cost allotment focuses on roll uping costs within functional countries. The chief advantage of ABC is that it minimises or avoids deformations on merchandise costs that might happen from arbitrary allotment of overhead costs. Stairss in development of an ABC System

ABC uses cost drivers to delegate the costs of resources to activities and unit cost as a manner of mensurating an end product. There are four stairss to implementing ABC.

1. Identify activities

The administration needs to set about an in-depth analysis of the operating procedures of each duty Centre. Each procedure might dwell of one or more activities required to bring forth an end product. 2. Assign resource costs to activities

This involves following costs to be objects to find why the cost occurred. Costss can be categorised in three ways: I. Direct – costs that can be traced straight to one end product. For illustration. the wood and pigment that it takes to do a chair. two. Indirect – costs that can non be allocated to an single end product. that is. they benefit two or more end products. but non all end products. For illustration. care costs or storage costs. three. General/administration – costs that can non be associated with any merchandise or service. These costs are likely to stay unchanged. whatever end product is produced. For illustration. wages of disposal staff. security costs or depreciation.

3. Identify end products

Identify all of the end product for which an activity section performs activities and consumes resources. End products might be merchandises. services or clients. 4. Assign activity costs to outputs

This is done utilizing activity drivers. Activity drivers assign activity costs to end products ( cost objects ) based on the ingestion or demand for activities.

ABC in pattern
Stairss to implement Activity-Based costing

1. Identify and assess ABC needs – Determine viability of ABC method within an organisation. 2. Training demands – Basic preparation for all employees and workshop Sessionss for senior directors. 3. Specify the undertaking range – Evaluate mission and aims for the undertaking. 4. Identify activities and drivers – Determine what drives what activity. 5. Make a cost and operational flow diagram – How resources and activities are related to merchandises and services. 6. Collect information – Collecting informations where the diagram shows operational relationship. 7. Construct a package theoretical account. validate and reconcile.

8. Interpret consequences and prepare direction studies.
9. Integrate informations aggregation and coverage.

ABC activities have been around for about 20 old ages and many companies in a assortment of sectors have implemented activity based thought. ABC and ABM have brought approximately extremist alterations in cost direction systems. The rules and doctrines of activity based believing apply every bit to service companies. authorities bureaus. procedure and fabrication industries. Management patterns and methods have changed over the last decennary and will go on to alter. Administrations have moved from pull offing vertically to pull offing horizontally. There has besides been a move from a map orientation to a procedure orientation.

However. direction information systems to track and supply information about the horizontal facets of concern have lagged significantly behind managers’ demands. ABC and ABM make full this information spread by supplying cost and operation information that mirrors a horizontal position. ABC focuses on accurate information about the true cost of merchandises. services. procedures. activities and clients. Using ABC. administrations gain a thorough apprehension of their concern procedures and be behavior during ABC analysis. Management so applies this penetration to better determination devising at operating and strategic degrees. This is so known as ABM. Simply. ABM is ABC in action.


This elaborate survey of how administrations are practically using ABC can be found on the BetterManagement. com web site ( to entree this survey you must register. and so snap on the nexus to activity based direction in the top left manus corner of the place page ) . Available from: World Wide Web. bettermanagement. com Accessed 4 November 2008 ] The survey was carried out in July 2005 to find the province of ABC within over 500 administrations across legion industries of different sizes and locations. It provides a utile and interesting penetration into how ABC is used in administrations.

Reported benefits

• ABC provides a more accurate method of bing of merchandises and services. It allows for a better and more comprehensive apprehension of operating expenses and what causes them to happen. • It makes dearly-won and non-value adding activities more seeable. so leting directors to concentrate on these countries to cut down or extinguish them. • It supports other direction techniques such as uninterrupted betterment. scorecards and public presentation direction. Reported drawbacks

• ABC can be hard and clip devouring to roll up the informations about activities and cost drivers. • It can be dearly-won to implement. run and pull off an ABC system. • Even in ABC some operating expense costs are hard to delegate to merchandises and clients. These costs still have to be randomly applied to merchandises and clients.


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