What Is Activity Based Costing?

During the 80’s, it be came apparent that the conventional techniques for recovering overheads were increasingly providing the management with cost information that was inaccurate and misleading. New techniques for overhead recovery was needed Innes,J. & Mitchell.F,(1991). In order to produce a more accurate costing system, Cooper and Kaplan in 1988 developed a more refined approach for assigning overhead to products and computing product costs and called this approach activity-based costing (ABC) (Colin Drury ,2001).

An article published by Mike Jeans & Michael Morrow (1989) summarizes that there are five main factors which led to the development of ABC. The factors are “management accounting practice has become distorted, direct labour has shrunk as a percentage of total cost for the majority of manufacturing companies, overhead costs are no longer a mere burden to be minimized, products have become more complex ,and the marketplace is more competitive”. It is because of all the reasons mentioned above, that companies needed a new costing system and hence the emergence of ABC.

What is activity based costing? Offtech Computing Pty Ltd, (2002) stated that Hicks (1999) has defined ABC as, " a concept around which it can construct an economic model of its business that will provide the accurate and relevant cost information necessary to support sound business decisions of all types”. Activity-based costing is a costing model that identifies the cost pools, or activity centres, in an organization and assigns costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or services.

(Narcyz Roztocki,1998) in his website and Jeans and Morrow (1989) both stated that cost objects consumes activities, which in return consumes resources and this consumption of resources is what drives cost.

Jeans and Morrow (1989) also discussed ABC approach and summarised it by saying that ABC is able to identify any factors or activities that has a direct cause-effect relationship with the resources consumed to produce a product. This means that ABC system traces rather than allocates each expense category to the particular cost object. In ABC, cost drivers are used to assign activity cost pools to products or services and this gives a better perspective of resource allocation