Activity Based Costing
Activity-Based Costing (ABC) is a method of assigning the organization's resource cost through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. ABC has predominately been used to support strategic decisions such as pricing, outsourcing and identification and measurement of process improvement initiatives.
Previously indirect cost had been arbitrarily added as a broad percentage of expenses onto the direct cost. However as the percentages of indirect or overhead cost has risen, this technique became increasingly inaccurate because the indirect costs were not caused equally by all the products. For example, one product might take more time in one expensive machine than another product, but since the amount of direct labor and materials might be the same, the additional cost for the use of the machine would not be recognized when the same broad percentage is added to all products. Consequently, when multiple products share common costs, there is a danger of one product subsidizing another.
Instead of using broad arbitrary percentages to allocate costs, ABC seeks to identify cause and effect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity. In this way ABC often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products.
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