Activity Based Costing

A detailed Summary of Activity Based Costing

In today's competitive economy, the cost structure is much more complex than that of the past, and there is a lot less room for error than that allowed in the more laid back economy of the past. Today's costing concerns arise from the growing disparity between direct and indirect product costs. American manufacturers have been pursuing a steady stream of manufacturing methods and technologies. The goal was simple and uniform: to reduce or eliminate direct costs. But as manufacturing has evolved, so has the structure of a product's cost. Direct costs, such as labor, are no longer the dominant cost of a product. The cost of indirect activities such as automation, marketing, sales, engineering, and order processing have dramatically increased. Overhead has grown to become the most expensive element of product cost structure.

This might not be so bad if conventional product costing systems could handle the shift in cost structure. Unfortunately, they don't. Most conventional systems allocate overhead based on some burdened rate (direct labor hours is a good example). This was acceptable when overhead was small and direct costs were high. But in today's automated factory, this can lead to disaster. Con

Now, using the ABC concept, the costs are apportioned according to a driver, the number of engineering change orders. (ECO's) The next graph shows the reallocation of overhead costs by the ABC method. Product B is now carrying its fair share of ECO processing costs. As would be expected, Product B actually costs five times more than Product A in terms of indirect activity consumption.

As you have seen, activity based costing can offer much clearer insight into the operations of a business than the conventional method .of the past. When ABC is used as a management system, it is a powerful tool for rethinking and improving products, services, processes and a company's market strategies.

Now guess what happens when these cost figures are used in pricing. Product A will probably be overpriced for the market, and Product B will be sold for less than its true production cost.

To see how bad the errors can be, look at the following chart. Conventional costing says that product B has a much lower overhead cost per unit ($4.80 vs. $7.20 for Product A). But this can't be so. Product B consumes five times as much engineering change activity as Product A. Product B should cost more to produce.

As already mentioned,

Some common words found in the essay are:
Based Costing, Product Product, overhead costs, direct labor, product cost, conventional costing, activity based costing, cost structure, engineering change, activity based, direct costs, five times, based costing, divided total direct, changes divided total, cost engineering changes, engineering changes divided,

Approximate Word count = 824
Approximate Pages = 3 (250 words per page double spaced)

Category: Miscellaneous

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Activity Based Costing

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