Activity Based Costing (ABC) Advantages and Disadvantages

activeness establish speak toing (ABC) Advantages and Disadvantages application Based Costing which is popularly known as ABC system has been considered as an frugal map of an organizations expenses and profitability based on organizational activities according to Kaplan R and Cooper R.An activity is an event, task or unit of work with a stipulate purpose, for instance, designing a product, setting up machines, operating machines, and distributing products by Horngren, Foster, Datar. According to Kaplan R.S Cooper R ABC system came in the mid-1980s to meet the need for true information controld by managers about live of resources demanded by individual products, function and customers. It emerged as competition moved from local to world(a) and from the efficient subprogram of direct push and machines.Absorption Costing also known as full monetary valueing is a traditional costing system developed in the 1900s, by which bangs incurred deep down a period were absorbed into the products by Kilgour D. The traditional acculturation costing was introduced at a clock time when engine room was simpler, competition was local, products were beat and not customised products and services, speed, quality and performance were not measurement for success in informant to Kaplan R.S Cooper R.Importance of Absorption Costing System or Activity Based CostingAccording to Horngren, Foster Datar, the importance of a costing system should depend on whether the company is producing one type of product and because could every last(predicate)ocate all overhead costs using one cost pool and one cost rate or whether the company is producing distinct contour of products and therefore need a system which could enable it apportion the total cost of resources faultlessly according to their usage of those resources. As companies began to expand and delve into producing mannequin of products, they began to notice that some products place more demand on their resources th an others.It became consequential to absorb overhead when products which are not the same but required different exertion processes or jobs which although the use the same facility but at a length of time according to Terry L. To ascertain how to apportion overheads to products or services, traditional absorption costing involves two stages the first stage is the allocation and apportionment and the due south stage is the use of absorption rate to absorb overheads into products. disk overhead Allocation Terry L overhead allocation is the assignment of all cost incurred to a single cost unit, centre account or time period.Overhead Apportionment This is a case where the costs incurred could not be identified with only one cost centre therefore the cost is share between the cost centres using that service, for instance, lighting cost would be shared between all the cost centres using a suitable prat, Terry L. It is important that the basis upon which costs are apportioned are rele vant, fair and equitable Terry L.Overhead Absorption Rate This is usually calculated at the first-class honours degree of a period therefore it is based on budgeted costs and production volumes, AAT units 89. The formula is as follows Total overheads of cost centreTotal number of units of absorption base applicable to cost centreAccording to Terry L before calculating absorption rate, the absorption base chosen has to reflect the characteristics of the prone cost centre. The basis most commonly used are direct outwear hrs for a labour intensive cost centre and the machine hour basis usually used where the cost centre is highly mechanised. With exception of the above two basis, other basis include Direct wages, Direct material, flowering cost and Cost unit.ABC System Activity Based Costing began in a manufacturing setting but has been more service -oriented than product oriented. assist Industries as much as manufacturing industries need ABC system to connect the cost resources they supply to the revenues earned by the individual products and customers serviced by these resources in reference to Horngren, Foster Datar.ABC System has three key stimulates are (1) With the system all costs used by a product whether covariant or fixed in the short-run or overheads(indirect costs)in the long-run are identified by creating cost pools as ABC is focused on long-run variable costs for instance as Terry L said, costs for supporting activities like stock handling, production scheduling and so on.Cost Pool Classifying all related costs to a particular activity together according to Terry L.(2) The second feature of ABC system is An amount of an activity performed in each cost pool is recognised as a basis of allocation for instance, set-up hours as a measure of set up activity. Horngren, Foster, Datar.(3) The third feature is that costs in a cost pool can sometimes be traced directly to products. Horngren, Foster, Datar.The Differences Between Traditional Absorp tion Costing and Activity Based Costing.The differences between the two costing system are easy to notice. Below are lists of some of themThe traditional absorption costing was introduced at the time when technology was simple, there was only local competition and not global, when products were standard not customised, from Kaplan S.R Cooper R.ABC system emerged at the time when competition had become global and fierce and had shifted from the efficient use of labour hours and machines, by Kaplan S.R Cooper R.The traditional costing uses mostly two allocation bases to allocate overheads to products direct labour basis for a labour intensive company and the machine hour basis for a highly mechanised company. These two bases would not capture the demand of a particular product on the resources of the organisation. There are no cause and effect relationship to an allocation base with the use of this method, Horngren, Foster, Datar.With ABC system, costs of activities within the organi sation are more accurately measured because the cost pools are properly structured with specific activity cost allocation bases which became cost drivers for the cost pool. Cost Driver factor influencing the level of cost from Terry L.In the traditional absorption system, absorption rates are based on predetermined figures thereby giving rise to under and over absorption of overhead. Under absorption arises when the estimated overhead is less than the actual overhead. Over absorption of overhead arises when the overhead absorbed exceeds the actual overhead from AAT Study text units 89.The measurement required to implement ABC system are costly as the system demands that circumspection should estimate costs of activity pool, identify and measure cost drivers for the cost pools to serve as allocation bases from, Horngren, Foster, Datar.The use of ABC system will require its activity cost rates to be updated regularly and a detailed ABC system consumes time, is difficult to underst and and operate, Horngren, Foster Datar.Illustration As an model of the differences between traditional absorption costing and activity based costing,with attention to set up activity, the effect of allocating all overheads using direct labour hours as against an ABC emphasis on individual activities, the name of the company shall be called Z. Z produces two kinds of lenses for an automobile company. The first product is a simple lenses, the second product is called complex lenses.Set ups involves trial runs, fine tuning, adjustments, wrong set-ups cause quality problems such as scratches . Each set-up requires different resources depending on the complexity of the operation. intricate lenses are produced in small batches because the mold has to be cleaned more often. Horngren, Foster Datar.According to Horngren, Foster, Datar, set-up data for simple lens and complex lens are round-eyed ComplexS3 lens CL5 lens Total(1) Quantity produced 60,000 15,000(2) Lens per batch 240 50(3) No of batches (1/2) 250 300(4) Set-up time per batch 2hours 5hours(5) Total set-up hours (3)*(4) 500hours 1500hours 2000hoursDirect manufacturing labour hours 30000hrs 9750hrs 39750hrsZ recognises total cost of set-ups comprising of allocated costs of process engineers, supervisors, set-up equipment of 300,000.Solution The table below shows how the set-up costs have been allocated to simple and complex lenses using direct labour hours and setup hoursSetup cost per direct labour hours(300,000/39750)=7.54717Setup cost per setup hours(300,000/2000)= 150Simple Complex TotalS3 lens CL5 lensCost allocated using direct labour hrs7.54717* 30000 7.54717*9750 226,415 73,585 300,000Cost allocated using setup hrs150*500 150*1500 75,000 225,000 300,000Implementing the Activity Based Costing SystemThe choice of implementing Activity Based Costing depends on the managers after evaluating the advantages and disadvantages, controlling the amount of details required and cost.ABC system enables manag ement to see their existing and predetermined cost of activities and business processes which then equips them with knowledge of the cost and profitability of the various products, services, customers and operating units according to Kaplan S.R, Cooper R. There are several steps the company could dole out to change the existing costing system. These areStep 1 List all the activities of the company performed by indirect and supportResources, for instance, material handling, schedule production and so on.Step 2 Find out how much the company is spending on each activity in the company.Step 3 Indentify the companys products, services and customers, Kaplan S.R, Cooper R.Step 4 Charge support overheads by their usage of the activity with emphasis on theCause-effect relationship.Recommendation ABC system is recommended since it provides more accurate productCosts. The system has been used successfully in some service industriesSuch as the Cooperative Banks to identify profitability, prod uct mixes,Improve efficiency and accomplish customers, Horngren, Foster Datar.