Controlling a budget
3. Activity based costing (ABC)
Activity Based Costing (ABC) is another technique that ultimately allocates indirect costs to products. ABC assigns costs to activities and then to products. Traditional costing methods assign overhead costs to products based on average absorption rates. ABC links indirect costs to products by allocating indirect costs to activities and then to products based on their usage of the activities. This method identifies cause-and-effect relationships in an attempt to accurately allocate costs to products. It is most useful when indirect cost allocation accuracy is important and when indirect costs form a large proportion of total costs. Activity based costing can be a useful aid to strategic decisions concerning processes, outsourcing and selling prices. However, there is an element of complexity as with all costing systems that absorb and redirect costs.
Four steps for activity based costing:
Recognise and list the activities in the value chain that are related to the production process of the product. Estimate a total cost for each of the activities listed in '1' above. Compute a cost-driver rate for each activity based on an allocation method that has a direct link to the cost of the activity. Apply these activity costs to products using the cost-driver rate
Future Practice Owner.
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