Definition and Description of Activity Based Costing (ABC)

Question

Please explain Activity Based Costing?

Answer

Activity Based Costing (ABC) seeks to identify more accurate costing attributed to goods sold, this can lead to pricing which better reflects the true cost – so may lead to better efficiency and profit margins. However, it is more complex. Traditional absorption costing divides indirect costs across all goods sold based only on volume, it does not consider that some goods may use more of the firm’s resources than others, and thus incur more cost. ABC captures the costs of goods by creating cost pools, and identifying cost drivers, for different activities. The cost of these activities is then divided between the goods that go through them. For example, consider a factory where two different goods are produced in equal quantities, and both go to the same packaging department, but one is packaged by a machine which uses twice as much electricity and maintenance. In absorption costing the energy and maintenance costs would normally be totalled and considered indirect costs, leading to inaccurate cost attribution as one uses twice as much. In ABC the activities would be tracked and costed separately, so that the higher cost of one machine can be attributed to the products that use it.

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