Activity Based Costing (ABC) Advantages and Disadvantages

occupation Based appeal ( alphabet) Advantages and DisadvantagesActivity Based following which is popularly known as alphabet dust has been considered as an economic map of an organizations expenses and positiveness viled on organizational activities gibe to Kaplan R and Cooper R.An drill is an event, task or unit of work with a specified purpose, for instance, designing a growth, set up implements, operating machines, and distributing products by Horngren, Foster, Datar. According to Kaplan R.S Cooper R rudiment agreement of rules came in the mid-1980s to meet the unavoidableness for accu set information compulsory by managers about monetary value of resources demanded by individual products, services and customers. It emerged as emulation moved from topical anesthetic to global and from the economic use of behave force back and machines. dousing Costing also known as in effect(p) addressing is a traditional costing system developed in the 1900s, by which b udget itemss incurred within a point in time were meshed into the products by Kilgour D. The traditional assimilation costing was introduced at a time when technology was simpler, competition was local, products were standard and not customised products and services, speed, quality and performance were not measurement for achiever in reference to Kaplan R.S Cooper R.Importance of preoccupation Costing organization or Activity Based CostingAccording to Horngren, Foster Datar, the splendor of a costing system should depend on whether the caller-up is producing cardinal type of product and therefore could exclusivelyocate all operating cost cost employ one cost family and one cost rate or whether the company is producing varied kind of products and therefore need a system which could enable it apportion the hail cost of resources accurately jibe to their usage of those resources. As companies began to expand and delve into producing variety of products, they began to no tice that near products place much demand on their resources than others.It became important to absorb overhead when products which be not the same but required different achievement 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 assignation and apportionment and the second stage is the use of absorption rate to absorb overheads into products.Overhead Allocation Terry L overhead tryst is the assigning of all cost incurred to a single cost unit, reduce reputation or time period.Overhead Apportionment This is a case where the be incurred could not be identified with only one cost centre therefore the cost is sh atomic number 18d between the cost centres using that service, for instance, lighten up cost would be shared between all the cost centres using a suitable basis, Terry L. It is important that the basis upon which cost are apportioned are relevant, fair and equitable Terry L.Overhead Absorption Rate This is usually calculated at the beginning of a period therefore it is based on budgeted cost 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 wedded cost centre. The basis most commonly employ are aspire labour hours 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 command wages, Direct material, Prime cost and Cost unit.ABC scheme Activity Based Costing began in a manufacturing setting but has been more service -oriented than product oriented. Service Industries as much as manufacturing i ndustries 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 features are (1) With the system all be used by a product whether variable or fixed in the short-run or overheads( indirect be)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 uniform stock handling, production scheduling and so on.Cost Pool Classifying all related costs to a particular employment together according to Terry L.(2) The second feature of ABC system is An center of an activity performed in each(prenominal) 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 Absorption 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 in the main 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 set and effect relationship to an allocation base with the use of this method, Horng ren, Foster, Datar.With ABC system, costs of activities within the organisation 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 low and over absorption of overhead. Under absorption arises when the estimated overhead is less than the unfeigned 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 management 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 regu larly and a detailed ABC system consumes time, is difficult to understand and operate, Horngren, Foster Datar.Illustration As an instance of the differences between traditional absorption costing and activity based costing,with concern 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 lense systemes for an automobile company. The first product is a simple lenses, the second product is called complex lenses.Set ups involves trial runs, o.k. tuning, adjustments, wrong set-ups cause quality problems such as scratches . Each set-up requires different resources depending on the complexity of the operation. Complex lenses are produced in small batches because the form has to be cleaned more often. Horngren, Foster Datar.According to Horngren, Foster, Datar, set-up data for simple lens and complex lens areSimple ComplexS3 lens C L5 lens Total(1) Quantity produced 60,000 15,000(2) Lens per batch 240 50(3) No of batches (1/2) 250 three hundred(4) Set-up time per batch 2hours 5hours(5) Total set-up hours (3)*(4) 500hours cl0hours 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 apparatus 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 election 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 management to see their breathing 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(prenominal) steps the company could take to change the existing costing system. These are metre 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(prenominal) as the Cooperative Banks to identify profitability, product mixes,Improve efficiency and encounter customers, Horngren, Foster Datar.