Activity Based Costing
Activity Based Costing (ABC) is a system of accounting that assigns costs to activities, rather than to outputs, in order to assign costs more accurately and fairly. It is a method of allocating overhead and direct costs to products and services, based on the resources they use. In this way, ABC is able to more accurately reflect the cost of producing a good or service, rather than simply assigning costs based on direct materials and labour costs.
Activity Based Costing can be used to determine the cost of each process and to identify the cost of activities that are outside the traditional production process. Costs are identified, and then allocated to those activities or products that consume those costs, enabling managers to establish better pricing strategies and to improve profitability.
The practical application of Activity Based Costing starts with an analysis of the organizations activities and their associated costs. This will involve taking all costs into account, including direct and indirect, that are related to activities in the value chain. By analysing the costs involved in production activities, such as engineering, design, purchase of materials, and manufacturing, and identifying the resources consumed, a better understanding of the cost associated with each process can be established.
Once these activities and their associated costs have been identified, the costs are then allocated based on the resources consumed during each of the processes. Resources are typically measured in terms of the labour, machine, and material costs associated with performing the activity. This, in turn, enables managers to accurately determine the costs of production and to decide which activities and processes are more cost effective.
ABC can also help organizations to identify cost and performance inefficiencies, and to develop improvement plans. For example, by analysing the cost of performing each activity and then comparing it to the cost of other activities and processes, an organization can determine which activities and processes are the most efficient and where improvements or changes can be made to improve overall performance and cost efficiency.
The benefits of using Activity Based Costing include improved accuracy when allocated costs to products and services, and improved profitability because of more accurate pricing decisions. This system can also help organizations to identify cost-saving areas and performance improvements that can be used to improve the competitive position of an organization.
In conclusion, Activity Based Costing can provide improved cost accuracy, better pricing decisions, and cost-saving opportunities when correctly applied. It can also help an organization to understand its activities and costs, and to develop more accurate financial performance models, enabling it to be more competitive in todays ever-changing market.
