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-: Activity-based costing is used to allocate
indirect costs to specific cost objects
based on the activities undertaken
in the production of the cost object.
It is the seven-step process
that starts with the identification of activities
that were involved in the production
of the organisations cost objects.
To make it a little simpler,
throughout the rest of this clip,
we will refer to cost objects as products,
but keep in mind that they
can be either products or services.
Once we have identified the activities
that go into producing our product,
we need to work out all the associated indirect costs.
That is, those costs that have a
cause and effect relationship with their activity.
These costs are then collated
and assigned to the activity cost pool.
Cost drivers or resource drivers
are those things that cause changes
to occur in the costs identified
for our activity cost pools.
Once we've determined what these cost drivers are,
for each cost pool,
we establish the number of transactions that have occurred
to incur those costs.
That is, if we understand
that the number of machines set-ups
is a cost driver for machine set-up costs,
then we need to determine
how many machines set-ups
have occurred or will occur,
that have caused the dollar value of the costs
in the cost pool to be incurred.
Dividing the value of the cost pool
by the number of cost driver transactions,
gives us a transaction cost rate
that is then used to allocate the cost pools
based on the actual cost driver transactions
per each activity.
It is important to note that the first few steps
in an activity based costing exercise
are resource intensive, complex and time consuming.
You need to be sure that the benefits
to the organisation will outweigh the associated costs.
So because the first few steps of so time consuming.
When you are learning the fundamentals,
you will usually be given information
that identifies activities, values the cost pools,
and the number of cost driver transactions.
But you still need to understand the key principles
that relate to choosing activities
and the underlying causes or drivers
of indirect costs attributable to these activities.
And you must be able to
apply this information in a costing exercise.
That is, you need to be able
to perform the mathematical calculations,
to determine the transaction cost rate
and to allocate cost pools
across the identified products or processes.
Once the total allocated amount
for each product has been calculated,
these can be divided by the number of units produced
to get a per-unit based cost.
This can provide useful information
for cost-volume-profit analysis,
and for strategic analysis
So why or when will implementing
an ABC system be a good idea?
It's been found that the benefits
to an organisation from ABC are usually the greatest.
When we have overheads
or indirect costs forming a significant portion
of the organization's total costs;
or there is a diverse product range
with significant variation in batch sizes
and complexity between products;
or the proportion of indirect costs
as a ratio to direct manufacturing costs are increasing,
or where there is the potential
for high costs to the business
for making inappropriate product decisions.
When diversity exists between product types
and product batch sizes,
ABC is much better at reflecting true costs.
A conventional cost allocation system
is likely to overstate the costs associated
with simple, but high volume products;
and will understate the cost
of complex or small batch products.