Definition and Explanation of Activity Based Costing System:
- Understand activity based costing
- How it differs from a traditional
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
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
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:
Non-manufacturing as well as manufacturing costs
may be assigned to products.
- Some manufacturing costs may be excluded
from product costs.
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.
allocation bases often differ from those used in traditional costing
The overhead rates or activity rates may be based
on the level of activity at capacity rather than on the budgeted level of
These differences from traditional cost
accounting systems can dramatically impact the apparent costs of products
and the profitability of products and customers.