Meaning and definition

The CIMA defines ABC as :

An approach to the costing and monitoring of activities which involves

tracing resource consumption and costing final outputs. Resources are
assigned to activities, and activities to cost objects based on consump-
-tion estimates. The latter utilise cost drivers to attach activity costs to
outputs.
• Meaning :

• Activity-based costing (ABC) is a methodology for more precisely allocating

overhead costs by assigning them to activities. Once costs are assigned to
activities, the costs can be assigned to the cost object that use those
activities. The system can be employed for the targeted reduction of
overhead costs.

• ABC works best in complex environments, where there are many machines
and products, and tangled processes that are not easy to sort out.
Conversely, it is of less use in a streamlined environment where production
processes are abbreviated.
• 1. Traditional product costing systems cannot report accurate product or service cost.
• 2. Traditional costing methods of overhead absorption use volume-related measures, such as
direct labour hours, or machine hours etc. But there are many overhead expenses which are not
related to physical volume.
• These are related to support activities such as material handling, material procurement, setting-
up of machines etc. These activities and their cost should not be allocated to products on the
basis of production volumes.
• 3. Traditional product costing systems assume that products or services produced consume all
resources in proportion to their production volumes. Thus products or services which take more
time to manufacture, generate more overheads. This assumption leads to under-costing of low
volume products or over-costing of high volume products or services.
• 4. Traditional costing system distorts products or service cost when the firm produces different
products or services which make diverse demand on resources. Products or services make diverse
demand on resources because of volume, process set-up, batch size or complexity.
• 5. This system fails to reflect the cause and effect relationship between activity consumption and
cost incurrence.
• 6. Traditional cost accounting systems are driven by the need to value stock rather than to provide
meaningful information for managing activities and controlling the causes of cost (i.e., cost
driver).
• 7. Overhead expenses are not a mere burden to be maintained.
Overhead costs for support functions, such as, product design, quality
control, customer service, production planning and sales order
processing are as important to the customer as physical process on
the shop floor.
• 8. This system fails to highlight inter-relationship among the various
activities of production departments.
• 9. Complexity in business has increased. Product ranges are wider.
Product cycles are shorter and demand for quality product is higher.
• 10. Market place is more competitive necessitating correct product or
service cost
ACTIVITY BASED COSTING
1. Overheads are related to activi- ties and grouped
into activity cost pools.
2. Costs are related to activities and hence are more
realistic.
3 Activity–wise cost drivers are de- termined.
4. Cost are assigned to cost objects, e.g. customers,
products, services, departments, etc.
5. Essential activities can be simplified and
unnecessary activities can be eliminated. Thus the
corresponding costs are also reduced/ minimized.
Hence ABC aids cost control.
TRADITIONAL ABSORPTION COSTING
1. Overheads are related to cost cen-
ters/departments.
2 Costs are related to cost centers and hence not
realistic of cost behaviour.
3. Time (Hours) are assumed to be the only cost driver
governing costs in all departments.
4.Costs are assigned to Cost Units i.e. to products, or
jobs or hours.
5. Cost Centers/ departments cannot be eliminated.
Hence not suitable for cost control.