With reference to accounting for overheads in the cost centers of an organisation, explain the relevance of activity based costing (ABC) in allocating costs to products.

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Activity based costing is a method of costing products in which an attempt is made to reflect more accurately in the product costs those, activities which influence the level of overheads. It refines the costing systems of products by focusing on the individual activities (that contribute to the overheads) as the fundamental cost objectives. An activity is defined as an event, task, or unit of work with a specified purpose, for example, operating machines, designing products, setting up machines etc. An activity can also be defined as a process or procedure that causes work.

Activity based costing (also called translation based costing) emphasizes the need to obtain a better understanding of the behaviour of overhead costs, i.e. what causes overhead costs and how do they relate to products. It recognizes that in the long run, most costs are not fixed, and it therefore seeks to understand the forces that cause overheads to change over time.

ABC appreciates the fact that overhead costs do not necessarily vary with the level of output produced or the complexity of the production process. In ABC therefore, non-unit related (non-volume) bases are used to absorb overheads into products because they capture the complexity and the diversity of the manufacturing process, such as the relationships between volume, batch size and order size.

The need for ABC may not be clear in labour based high volume environments, because the costing errors may not be significant. However, the costing errors will be significant in automated manufacturing processes and in companies that manufacture products in highly varied lot/batch sizes because they have a high percentage of non-volume related costs.

ABC recognizes that performance of activities triggers the consumption of resources that are recorded as costs. It assigns cost to the transactions and activities performed in the organization, and allocate them appropriately to the products according to each product‟s use of the activities. ABC therefore traces costs to the activities identified, then assigns the costs to products using both volume and non-volume related drivers.

A common way of applying costs to products in ABC is on the basis of the time the uncertainty takes to move through a fire work cell. A work cell is a product oriented centre including the machines and tools necessary to produce a family of products. Other common basis used in ABC include 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 auxiliary activities (such as ordering, receiving, material handling costs etc) are identified.

2. Cost Pooling –Involves the assigning of costs to cost centres or cost pools. A cost centre is created for each activity e.g. the total costs of all set-ups might constitute one cost centre for 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 driven by the number of purchase orders processed.

The use of ABC therefore requires a change in the way overheads are classified by an organization. In a traditional costing system, overheads would be charged to products using at the most two absorption bases, usually labour hours and machine hours. ABC system, on the other hand, utilizes many cost drivers to absorb overheads into products. It is therefore claimed, and justly so, that the use of ABC produces a more realistic service or product cost, especially for service organizations and organizations with high overhead costs. However, managers used to the old system may resist the use of the ABC. Also, selecting the most appropriate cost driver from a host of them may not be a straight forward activity. The relationship between the cost driver and the activity may also not be easy to determine.

The analysis of the various activities that are involved in production may be a time consuming and tedious exercise.

However, ABC is bound to produce the most accurate and the most relevant data for an
organisation‟s planning, decision making, performance evaluation and control purposes.

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