The process of identifying activities in an organisation and assigning costs under the Activity Based Costing (ABC) system

Sample Solution

Q1. Activity Based Costing (ABC) Process:

Activity-Based Costing (ABC) assigns indirect costs (overhead) to products or services based on the activities that cause them. Here's the process:

1. Identify Activities: Define the activities that consume resources within the organization. Examples include order processing, machine setups, inspections, etc.

2. Cost Pool Allocation: Group related activities into cost pools based on the resources they consume. Each cost pool will represent a category of indirect costs.

Full Answer Section

1. Cost Driver Identification: For each cost pool, identify a cost driver. This is a factor that causes the cost to vary. Examples include number of transactions, machine hours, direct labor hours, etc.

2. Cost Rate Calculation: Divide the total cost of each cost pool by the total amount of the cost driver. This gives you a cost rate per unit of the cost driver.

3. Cost Allocation: Assign indirect costs to products or services based on their usage of the cost drivers. Multiply the cost rate for each cost pool by the amount of the cost driver used by each product or service.

Example:

A company manufactures chairs and tables. They identify two cost pools:

• Material Handling: Cost driver = Number of parts used
• Machine Setup: Cost driver = Number of setups required

The total cost of Material Handling is $10,000, and the total number of parts used for chairs and tables is 1,000 and 2,000, respectively. The total cost of Machine Setup is $5,000, and the number of setups required for chairs and tables is 10 and 20, respectively.

Cost Rate Calculations:

• Material Handling Rate = $10,000 / 3,000 parts = $3.33/part
• Machine Setup Rate = $5,000 / 30 setups = $166.67/setup

Cost Allocation:

• Chair: Material Handling = 1,000 parts * $3.33/part = $3,330; Machine Setup = 10 setups * $166.67/setup = $1,666.67
• Table: Material Handling = 2,000 parts * $3.33/part = $6,660; Machine Setup = 20 setups * $166.67/setup = $3,333.33

This approach assigns indirect costs more accurately to products based on their actual usage of activities, leading to a more precise costing system.

Note: This is a simplified example. Real-world ABC systems can involve multiple activities, cost pools, and cost drivers.