21974615 activity based costing assignment (1)
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Activity Based Costing
Activity Based Costing
Activity-Based Costing (ABC) is a costing model that identifies activities in an
organization and assigns the cost of each activity resource to all products and services
according to the actual consumption by each: it assigns more indirect costs (overhead)
into direct costs.
Activity Based Costing (ABC) is actually a method for developing cost
estimates in which the project is subdivided into discrete, quantifiable activities or a
work unit. The activity must be definable where productivity can be measured in units
(e.g., number of samples versus man-hours). After the project is broken into its
activities, a cost estimate is prepared for each activity. These individual cost estimates
will contain all labour, materials, equipment, and subcontracting costs, including
overhead, for each activity. Each complete individual estimate is added to the others
to obtain an overall estimate. Contingency and escalation can be calculated for each
activity or after all the activities have been summed. ABC is a powerful tool, but it is
not appropriate for all cost estimates.
In this way an organization can establish the true cost of its individual products and
services for the purposes of identifying and eliminating those which are unprofitableand lowering the prices of those which are overpriced.
In a business organization, the ABC methodology assigns an organization's resource
costs through activities to the products and services provided to its customers. It is
generally used as a tool for understanding product and customer cost and
profitability. As such, ABC has predominantly been used to support strategic
decisions such as pricing, outsourcing and identification and measurement of process
improvement initiatives.
Objectives of Activity Based Costing:
The primary of objective of ABC systems are as follows:
1) To improve the accuracy of product costs by carefully changing the type andnumber of factors used to assign costs
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Methodology
Direct labor and materials are relatively easy to trace directly to products, but it is
more difficult to directly allocate indirect costs to products. Where products use
common resources differently, some sort of weighting is needed in the cost allocation
process. The measure of the use of a shared activity by each of the products is known
as the cost driver. For example, the cost of the activity of bank tellers can be
attributed to each product by measuring how long each product's transactions takes at
the counter and then by measuring the number of each type of transaction.
Activity Based Costing Definition
ABC can be defined by the following equation:
y C/A = HD + M + E + Sy where C/A = Estimated cost per activityy H = Number of labour hours required to perform the activity one timey D = Wages per labour houry M = Material costs required to perform the activity one timey E = Equipment costs to perform the activity one timey S = Subcontracting costs to perform the activity one time
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Limitations
y Even in activity-based costing, some overhead costs are difficult to assign toproducts and customers, for example the chief executive's salary. These costsare termed 'business sustaining' and are not assigned to products and customers
because there is no meaningful method. This lump of unallocated overhead
costs must nevertheless be met by contributions from each of the products, but
it is not as large as the overhead costs before ABC is employed.
y Although some may argue that costs untraceable to activities should be"arbitrarily allocated" to products, it is important to realize that the only
purpose of ABC is to provide information to management. Therefore, there is
no reason to assign any cost in an arbitrary manner.
Use of Activity Based CostingMethodology
y ABC methodology is used when a project can be divided into definedactivities.
y These activities are at the lowest function level of a project at which costs are
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tracked and performance is evaluated. Depending on the project organization,
the activity may coincide with an element of the work breakdown structure
(WBS) or may combine one or more elements of the WBS. However, the
activities must be defined so there is no overlap between them. After the
activity is defined, the unit of work is established. All costs for the activity are
estimated using the unit of work.
y The estimates for the units of work can be done by performing detailedestimates, using cost estimating relationships, obtaining outside quotes for
equipment, etc. All costs including overhead, profit, and mark-ups should be
included in the activity cost.
y It helps to identify inefficient product, department and activityy It helps to allocate more resources on profitable product, department and
activity
y It helps to control the cost at individual level and on departmental levely It helps to find unnecessary costsIdentification of Activitiesy When defining an individual activity, the cost estimator must balance the need
for accuracy with the amount of time available to prepare the estimate. An
estimator may be able to develop an extremely accurate cost estimate by
defining smaller and smaller activities; however, the amount of time required to
prepare ABC estimates for each of these activities may not justify the increased
accuracy. The total estimated project cost may be sufficiently accurate if 10
activities are used instead of 15. On the other hand, reliable cost information
may not be accessible if the activity categories are too general. Since the
activity is the basis for the estimate, it is very important that the activity be
selected correctly.
Application of activity based costing
ABC can be a useful cost estimating tool for nonconventional and construction
projects. However, there are some activities that are more appropriately estimatedusing other cost estimating techniques. For example, site security may always be
required at some facilities regardless of the number of employees at the facility or
work being conducted at the facility. ABC estimating is especially useful in instances
where the number of activities is uncertain or may change during the estimate process.