Definition and Explanation of Activity Based Costing System:

Learning Objectives:

1. Understand activity based costing system.
2. How it differs from a traditional costing system?

Activity based costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore "fixed cost".

Activity based costing system is used to determine product costs for special management reports. This system is ordinarily used as a supplement to the company's usual costing system. Most organizations that use ABC system have two costing systems--the official costing system that is used for preparing external financial reports and the activity based costing system that is used for internal decision making and for managing activities.

In traditional cost accounting systems, the objective is to value inventories and cost of goods sold for external financial reports in accordance with the generally accepted accounting principles (GAAP). In activity based costing (ABC) system the objective is to understand overhead and the profitability of products and customers and to manage overhead. As a consequence of these differences in objectives, "best practice" activity based costing system differs in a number of ways from traditional cost accounting.

In activity based costing:

1. Non-manufacturing as well as manufacturing costs may be assigned to products.
2. Some manufacturing costs may be excluded from product costs.
3. A number of overhead cost pools are used, each of which is allocated to products and other costing objects using its own unique measure of activity.
4. The allocation bases often differ from those used in traditional costing system.
5. The overhead rates or activity rates may be based on the level of activity at capacity rather than on the budgeted level of activity.

These differences from traditional cist accounting systems can dramatically impact the apparent costs of products and the profitability of products and customers.

 

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