Accounting

Activity based costing approach to designing a cost system tries to accumulate the total overhead costs for every singly activity being carried on in an organization, and then attempts in assigning the costs of these identified activities to the services or products caused by those activities.

It is a system of managerial accounting that attempts to determine the costs of the activities in an organization, without distortion. It provides a method of looking at the costs by providing methods for dissecting the activities which cause such costs.
The main goal of this cost approach is to trace the cots to the identified services and products rather than allocating then these costs being allocated randomly to such products or services. In activity based costing approach most of the manufacturing overheads can be individually related to individual products.

Designing of a ABC accounting system involves four steps, namely
Identification at organizational level of all the activities carried.
Assigning cost centers to activities
Determination of relevant cost drivers for each of the activities identified above
Allocating the cost of the activities to the products or services based on the consumption of such activities by different productsactivities.

Overhead absorption rate (OAR) under the current system
OARBudgeted overheadsBudgeted level of activity
OAR 990,000 9 millionOAR11  of list priceOverhead charge for order A  11  of  1,400   154
Overhead charge for order B  11  of  1,000   110

Rate per cost driver under activity-based costing (ABC) approach
Invoice processing
Cost per invoice20  x  290,0009,000 invoicesCost per invoice 6.44 per invoice
Cost per invoice line80  x  290,00025,000 invoice lines
Cost per invoice line 9.28 per invoice
Packing
 34 for the large package,  27 for the small package.
Delivery
Loading cost per journey 50,0001,000 journeys
Loading cost per journey 50 per journeyThe total number of small packages that a lorry can carry are 12, so the loading costs are  5012   4.17 per small package.
The total number of large packages that a lorry can carry are 6, so the loading costs are  506   8.33 per large package.
 Mileage
Mileage costs 200,000 -  50,000350,000 miles
Mileage costs 0.43per journey
Other overheads
Cost per order 240,0009,000 orders
Cost per order 26.67 per order
Order A
Order B
Invoice processing cost6.446.44 6.44 x 319.32- 6.44 x 9-57.96Packing costs2734Delivery costs4.178.33 0.43 x 104.3- 0.43 x 48-20.64Other overhead costs26.6726.67Total over head charge for the order87.9154.04
 c)
i) The existing system of allocation of overheads is very simple but the existing method does not make any attempt at all to link the overhead costs to the cost drivers that cause those costs. The present system of allocation of overheads spreads the overhead costs at a single rate of 11 of the total list price.

The strengths of the Activity Based Costing (ABC) system can be summarised as follows
ABC recognises the complexity of the manufacturing processes.

It enables the companies to asses the profitability of its products in a competitive environment more effectively, it enables the managers to assess and control what drives overhead costs.
ABC can be said to have taken the management accounting way ahead than its traditional style of allocation of costs.

However the ABC system does have some serious flaws, such as
It is sometimes difficult to identify costs and link them to a particular activity.

The costs of switching to and implementing ABC can exceed the benefits the management of a company expect to derive from it.

Single cost drivers can not be reasonable expected to explain the behaviours of all items in the total cost pool.

It fails to allocate some of the costs for which it is rather impossible to identify a particular cost driver, for example depreciation costs.

ii) ABC approach may help the management in answering few critical questions relating to the analysis of costs by activities performed in an organization, including
How much time is being spent in the activities performed
How many resources are deployed to perform these activities

What value does the activity under consideration create for the company as a whole
The ABC system of accounting is as simple as the current overhead allocation system being in use by the company however unlike the existing system the ABC method allocates the overheads costs on the basis of cost drivers (factors that result in the incurring of costs).

Charging overhead costs on the basis of cost drivers, will provide the company with more accurate results and provide more useful information about the cost structure of the orders, this will help the company in effective monitoring of costs and costs drivers that will help the company in improving its cost control. Once the company gets full information about its cost structure, the management of the company can make efforts to control the activity of the cost drivers in order to reduce their costs associated with the orders.

d) The conditions under which activity based costing can be most effective depends on the accurate identification of the costs allocated to the different service or products f the company and appropriate identification of the costs drivers. In activity based costing systems the costs of direct material and direct labour can be directly associated to the products or services in the company.

It is of prime importance that the costs that vary depending on the production volumes in the company should be traced to the products by using appropriate cost drivers that are volume linked, whereas, overheads that do not vary depending on the production volumes, but vary depending on other activities must be linked to the products by using by using cost drivers that are activity linked.

The information that is usually provided by an Activity Based Cost accounting approach can support the management in planning, controlling and making right decisions about its products. It is however important that before implementation of Activity Based Cost accounting approach, the management of a company analyzes the activities in the organization to help it determine the extent to which such activities occur and the relationships between such activities and their related costs.

The Information collection procedure can also be used as a basis by the company for its future planning and budgeting. Once the budgeted production level is set by an organization, the information database can help the management to determine the number of times the identified activities will be carried out by the company during its operations. The management of the company can also establish budgets by multiplying the cost per activity with the budgeted activity levels of the organization.

The information technology database may also be helpful in providing the management with an insight to the ways in which costs were structured and incurred by the products or services. ABC approach makes it possible to some extent to control and manage costs by controlling and managing the activities that are linked to such costs by providing a measure to monitor the performance measures.