Absorption costing was developed in a time when most organizations produced only a narrow range of productsand overhead costs were only a very small fraction a total costs. Also there were similar operations and products consumed similar proportions of overhead. The benefits of more accurate systems for overhead allocation would probably have been relatively small while information processing costs were high. In recent years has been a dramatic fall in the costs of processing information and due to advanced manufacturing technology (AMT), overheads are likely to be be more important. The support activities such as setting-up, product scheduling, inspection and data processing have increased due to AMT and manufacture of a wide range of products. Traditional costing systems assume that all products consume all resources in proportion to their production volumes tend to allocate too great a proportion of overheads to high volume products and too small proportion of overheads to low volume products. Activity based costing (ABC) attempts to overcome this problems.
ABC is an alternative approach to the traditional method of absorption costing to link overhead costs to the products or services that cause them by absorbing overhead costs on the basis of activities that ‘drive’ costs (cost drivers) rather than on the basis of production volume. ABC is most beneficial to a company when there are high levels of overheads, multiple products, differing activities and products that make different use of different activities. The fundamental difference between the approach taken by ABC and traditional costing systems is that traditional costing methods uses a single measure of activity (typically labour hours or machine hours) to attribute production overhead costs to cost units while ABC approach recognizes that costs are generated by many different activities not just a single activity.
The ABC approach could be used as an alternative to absorption or marginal costing in a job batch, contract, service or process costing system. The service industry has found the ABC approach particularly useful in tackling the problem of identifying the costs of individual services with a common cost base such as banks, insurance companies and the hotel and leisure industry have been some of the major users of ABC technique in attempt to improve the accuracy of their costing information.
The Development for Activity Based Costing (ABC)
