Activity based costing (ABC)

In traditional costing, direct material, direct labour and direct expenses are identified with the jobs and all other expenses are accumulated under the head “overheads” and are charged to the jobs on the basis of one or two measurements such as direct labour cost or direct material cost of the jobs.

Proponents of activity based costing first brought out the fact that product costs derived by using traditional costing techniques are giving wrong information. The actual product cost of certain jobs is high but traditional costing system is reporting a low cost for them. If the selling price is determined on the basis of such wrong low cost, at the end of the year, companies find that they have not earned the anticipated profits.

In activity based costing, all the costs which are classified as overheads in traditional costing system are accumulated under various activities which are carried out in the organization. From the activity cost for a period, and the number of times the activity is carried out in the period, cost for doing the activity once is ascertained. Then an account is maintained each time the activity is carried and the job responsible for performing the activity is recorded. Therefore the activity cost can be charged to the job.

Thus the job cost, now comprises of direct material cost, direct labour costs, direct expenses and costs of each of the activities consumed by the job.

Activity based costing provides a more realistic estimate of costs of products.

Normally compared to traditional costing system, ABC system provides lower cost figures for standard products and higher cost figures for nonstandard orders.