Define “Activity- Based Costing” and explain how it operates in practice

Management Accounting Block Revision Mock Exams

On the basis of the time the inventory takes to move through a given work cell. A work cell is a product-oriented center including the machines and levels necessary to produce a family of products. Other common basis used in ABC includes the number of purchase orders, the number of material handling hours and the number of set up hours.

The ABC System can therefore be described as constituting the following stages.

1. Identifying the main activities in the organization: The main organizational activities such as machine related activities, direct labour related activities as well as auxiliary activities (such as ordering, receiving, material handling costs etc) are identified.
2. Cost Pooling: Involves the assigning of costs to cost centers or cost pools. A cost center is created for each activity e.g., the total costs of all set-ups might constitute one cost center of all set-up related costs.
3. Identifying the cost drivers: Cost drivers are the factors that cause an activity to occur. They therefore influence the cost of a particular activity. Cost drivers capture the demand placed on an activity by a product for example; purchasing department costs may be done by the number of purchase orders processed.
4. Absorption of Overheads to products: Using the selected cost drivers, the overhead costs are applied to or absorbed by the products depending on the level of activities that the product has consumed.

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