Allocation of overheads under ABC

The short-term variable costs should be identified to products using volume related cost drivers such as direct labour hour, direct material cost, machine hours etc. Kalpan and Cooper claimed that volume related cost drivers are inappropriate for tracing long-term variable costs to products because they are driven by complexity and variety and not by volume and the key to understanding what causes (drivers) overhead costs in transactions undertaken by support departments costs and factory overheads to product lines under ABC system is shown in the following figure:

Steps to Develop ABC System:

1. Identify the main activities performed in the organization, such as manufacturing, assembly etc., as well as support activities, including purchasing, packing and dispatching.
2. Identify the factors which influence the cost of each activity- the cost drivers.
3. Collect accurate data on direct labour, material and overhead costs.
4. Establishing the demands made by particular products on activities, using the cost drivers as a measure of demand.
5. Trace the cost of activities to products according to a product’s demand for each activity.

The rules developed by Kaplan and Cooper for this process is:

1. Focus on expensive resources, thus directing attention to resource categories where the new costing process has the potential to make big differences on product cost.
2. Emphasis on resources whose consumption varies significantly by product and product type-look for diversity.
3. Focus on resources whose demand patterns are un-correlated with traditional allocation measures.

Thus, ABC is the process of tracing costs first from resources to activities and then from activities to specific products. The technique of ABC lays the importance of different costs for different purposes and the identification of just those costs, which are relevant to a particular decision. However, it does not challenge the conventional accounting methods and theory; instead, it refines the ideas and concepts of conventional methods.

Traditional Versus ABC Approach to Designing a Costing System:

In traditional approach, there is lack of cause and effect relationship between the cost allocation bases and indirect cost pools because one or a few cost pools for each department or entire plant having little homogeneity are used. In ABC approach, many homogeneous indirect cost pools for various activity areas rather than a department or entire plant are used. There is a cause and effect relationship between the cost allocation bases and the indirect cost pools.

The traditional approach usually uses a few pools of indirect costs, so cost allocations are of intently based on broad averages. The costs of products thus, ascertained may be either over-costed or undercoated which may lead managers to make wrong pricing decisions resulting in loss of market share by fixing higher selling prices or selling prices for some products may be below the costs incurred to produce them. Activity based costing is a rational way of assigning indirect costs to various activities and pricing decisions taken by managers will be rational.

The activity based job costing method or process costing method is helpful in ascertaining areas where cost reductions are possible. Activity based costing can lead to improved decision making such as fixing selling price and pinpointing the area where cost reduction is possible because it provides more detailed information about various activities involved in a product or service.

Activity based principles can be successfully applied to the art of budgeting. Activity based budgeting is an approach to budgeting that lays emphasis on budgeting the costs of activities necessary to produce and sell products and services. Activity based budgeting is especially useful in case of budgeting of indirect costs.

Important steps in activity based budgeting are as follows:

1. Determining the demand for each individual activity on the basis of budgeted production.
2. Determining the budgeted cost of performing each activity.
3. Ascertaining the actual cost of each activity.
4. Comparing the actual cost with the budgeted cost of each activity, noting down the difference and taking corrective action, wherever necessary.