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ABC method of costing involves the identification of the factors( cost drivers) which cause the costs of an organization's major activities. Support activities are charged to products on the basis of their usage of the factor causing the overheads.
* For costs that vary with production level in the short term, the cost driver will be volume based related (Labour or Machine hours).
* Overheads that vary with some other activity ( and not volume of production) should be traced to products using transaction-based cost drivers such as production runs or number of orders.
The major ideas behind activity based costing are as follows:
* Activities cause costs
* Producing products creates demand for the activities.
* Costs are assigned to a product on the basis of the product's consumption of the activities.
An ABC system operates as follows.
1. Identify an organization's major activities
2 Identify the factors which determine the size of the costs of an activity (cost drivers).
3 Collect the costs associated with each cost driver into cost pools
4 Charge costs to products on the basis of their usage of the activity. Normally a product's usage of an activity is measured by the number of the activity's cost driver it generates.
