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BBA Cost Accounting Topic wise Study Material Of Activity Based Costing

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BBA Cost Accounting Topic wise Study Material Of Activity Based Costing
BBA Cost Accounting Topic wise Study Material Of Activity Based Costing


Learning objectives

  • Inadequacies Of Traditional Cost Systems
  • Activity Based Costing- Definition And Meaning
  • Objectives Of ABC System
  • Steps In Implementation Of ABC System
  • Meaning Of Cost Pools And Cost Drivers
  • Advantages And Limitations Of ABC
  • Use Of ABC Information In Decision Making
  • Activity Based Budgeting And Activity Based Management
  • Activity Based Accounting

Bba Cost Accounting Topic wise Study Material Of Activity Based Costing

Introduction TO Activity Based Costing

The cost accounting includes collecting, classifying, processing, analyzing and reporting of information to managers in their planning and control activities and information system to be developed to help in decision making within the firm. Traditional accounting focused on product costing by tracing direct costs to the product and indirect costs are allocated through cost centres. The direct cost s will be in proportion to the volume of production and the indirect costs like production, administration, marketing and distribution overheads etc., are apportioned depending upon the method used and absorbed to the individual product. The basis of apportionment of overheads may be based on machine hours, labour hours, direct costs, input, output, etc. these normal methods of apportionment have some bottlenecks which tend to misinterpret regarding proration of common costs of different functions added to the product cost. The conventional cost system use direct labour consumption as the primary means of apportioning overhead. This proved adequate when the overhead cost of indirect activities was a small percentage compared to direct labour consumption in actual making of products. The increased technology and automation has reduced the direct labour substantially, leaving indirect activities as a far more significant cost factor. Therefore, using direct labour as primary apportioning device can cause significant costing distortions and poor strategic planning. The cost information is normally reported too late to support improvement efforts and it is not reported by activity.

The incorrect cost information can lead to face the following dangers:

  • Emphasising and focusing on wrong products, wrong customers, wrong markets.
  • Neglecting and missing profitable opportunities.
  • Design of products that unnecessarily raise costs.
  • Moving of production to other places, which will increase cost instead of decrease in costs..
  • Customer orientation is neglected.
  • Acquisition of wrong type of equipment.
  • Centralisation of cost control activities and adoption of cost cutting programmes.

Bba Cost Accounting Topic wise Study Material Of Activity Based Costing

Inadequacies of Traditional Cost Systems

The cost of product under traditional cost system is not accurate due to following reasons:

  • The conventional costing system has developed convenient overhead recovery basis and blanket overhead recovery are acceptable when valuing stocks for financial reporting, but they are inappropriate when used for decision making and typical product strategy decisions. Such decisions have implications over 3 – 5 year and over this period many fixed costs become variable.
  • The traditional fixed verses variable cost split is often unrealistic since, as business grows they often become more complex.
  • In case of companies manufacturing and selling multiple products usually make decisions on pricing, product mix, process technology etc., based on distorted cost information due to difficulties in traditional costing system in collection, classification, allocation and recovery of overheads to individual products.
  • The cost structure is changing especially when making direct labour component to small proportion.
  • Traditional accounting was confined merely to furnishing information at product level. The new manufacturing technology demands the feedback of performance while production is still in progress rather than history.
  • There is also an urgent need to integrate the activity measurement and financial measurement.

Therefore in order to overcome the inadequacies of traditional methods of absorption of indirect costs and short –term biasing of marginal costing, activity based costing (ABC) has been researched. The new global competitive environment has cause to redesign the traditional manufacturing systems into world Class Company by adopting new ways of conducting business, new ways of measuring performance and striving for improvement in all aspects of a company’s business. The goal of a world class company is to profitably meet the needs of its customers. Therefore the cost system in a world class company should enable:

  1. Customer orientation o f cost information.
  2. Reveal the profitability of customers and products.
  3. The reasonableness of costs to be incurred for generating cost information.
  4. Identifies the opportunities for improvement.
  5. Enable to meet customers’ expectations profitably.
  6. Encourage the continuous improvement.

Bba Cost Accounting Topic wise Study Material Of Activity Based Costing

Activity Based Costing: Definition and Meaning

CIMA official terminology defines ABC as “cost attribution to cost units on the basis of benefit received from indirect activities e.g., ordering, setting – up, assuring quality”.

ABC has been defined as “the collection of financial and operational performance information tracing the significant activities of the firm to product costs”.

Professors Kaplan and Cooper of Harward University has pioneered the ‘activity based costing’ concept. ABC is an attempt to ascertain more accurate product cost by redesigning the allocative system of support overheads like inspection, dispatch, production planning set-up, tooling and similar costs. ABC is a recent development in cost accounting which attempts to absorb overheads into product costs on a more realistic basis. Supporters of the technique argue that many costs are unnecessarily treated as common costs and are arbitrarily absorbed using a basis such as direct labour hours , machine hours, etc. many organisations have now adopted advanced manufacturing technology (AMT) with the result that overheads are increasing and labour costs are becoming a smaller portion of total costs. Costing systems which absorb overheads on a direct labour basis are therefore, not relevant in an AMT environment. The basic idea of ABC is that costs are grouped according to what drives them or causes them to be incurred. The cost drivers are then used as an absorption base.

Activity based costing is the method of cost attribution to cost units on the basis of benefits received from indirect activities i.e., ordering, setting – up, assuring quality etc. It emphasises links between performance of particular activities and the demands that these activities make on the resources of the organisation. Methodology in allocation of overhead is different in ABC system under ABC, cost pools are created for each activity and such activities are related with each type of product to determine the cost of such product i.e. cost of only those activities are charged to the product which go in the making of the product. The technique of ABC involves identification of production path identification of activities that go into making a product m selection of suitable drivers, creation of cost pools , calculating the overhead application rate and allocation of the costs based on the application rate.

ABC is a method of measuring the cost and performance of activities and cost objects. Assigns cost to activities base on their use of resources and assigns cost to cost objects based on their use of activities. ABC recognises the causal relationship of cost drivers to activities. ABC is a method of measuring the cost and performance of activities, products and customers. In product costing applications, ABC allows costs to be apportioned to products by the actual activities and resources consumed in producing marketing, selling, delivering and servicing the product. The ABC system aims to overcome the drawbacks by cutting across conventional departmental boundaries. Costs are grouped into ‘pools’ according to the activities which drive them. The activity cost driver rates are identified as a means of tracing the cost of each activity to the product cost. ABC lays importance on different costs for different purpose and the identification of those costs which are relevant to a particular decision. The product costing using ABC is shown in figure.

Objectives of ABC

The primary objectives of ABC systems are as follows:

  1. To improve the accuracy of product costs by carefully changing the type and number of factors used to assign costs, and
  2. To use this information to improve product mix and pricing decisions.

The important objectives of ABC systems are summarised below:

  • To identify value – added activities in transaction.
  • To chalk out ways to eliminate non – value added activities.
  • To attach costs in response to the price resistance demonstrated by customers.
  • To distribute overhead on the basis of activities.
  • To validate the success on the quality drive with ABC.
  • To ensure accurate product costing for decision – making process.
  • To provide high quality information about activities, customers, non – manufacturing activities.
  • To focus the high – cost activities.
  • To identify the opportunities for improvement and reduction of costs.
  • To recognise the opportunities for profitably shifting the focus toward more profitable products, services and customers.

Bba Cost Accounting Topic wise Study Material Of Activity Based Costing

Steps in ABC System

The activity based cost system is summarised in the following steps:

Step 1 – Process Specification

This involves identification of different stages of the production process , the commitment of resources to each processing time and bottlenecks. This will provide a list of transactions, which may, or may not, be defined as ‘activities’ at a subsequent stage.

Step 2 – Identify Main Activities

The next step in ABC system is to identify the main activities in the organisation. An aggregate of closely related tasks is called an ‘activity’. For example, customer processing activity involves a series of acts like receiving orders from customers, interacting with production regarding capacity to produce, giving commitment to the customer regarding delivery time etc. thus any activity can comprise of one or more of tasks which are associated with one another to accomplish a goal or objective. Example include: materials handling, store keeping purchasing, inspection, dispatch, assembly, set – up, maintenance and so on. This ensures aggregation or grouping of common activities and elimination of immaterial activities. Activities are categorised into primary activities and support activities.

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