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In this article I wish to focus on activity-based costing or as it is more commonly referred to ‘ABC’. This technique re-examines the problem that has faced accountants and accounting technicians for decades — that of the allocation and absorption of overhead.

Activity-based costing

Students of management accounting are faced with a whole new language which surrounds costing and managerial finance methods and techniques. Terms such as cost and value management; cost reduction, value analysis, quality assurance processes and activity based costing all add to the students’ financial vocabulary.

In this article I wish to focus on activity-based costing or as it is more commonly referred to ‘ABC’. This technique re-examines the problem that has faced accountants and accounting technicians for decades — that of the allocation and absorption of overhead.

Traditional pricing method has been based upon absorption costing principles and the treatment of overhead usually followed a set procedure:

  • cost centres are identified and established within the business;

  • cost centres may be producing or service centres;

  • wherever possible a direct charge is made to a cost centre i.e., allocated overhead;

  • where overhead is jointly incurred, it is apportioned to the cost centres on some equitable base;

  • the overhead cost for the service centre is then transferred to producing centres;

  • the total overhead cost for each producing centre is then divided by, for example, machine or labour hours per cost centre;

  • overhead recovery rates are then determined;

  • these are then used to absorb the overhead to products;

  • in the short-run, if planned activity levels are actually achieved, then overhead may be fully recovered.

Such techniques may be used successfully where there is a limited product range and predetermined rates are well planned on achievable production volumes.

Case study

Cuecraft is an SME which manufactures high quality snooker and pool cues. For a number of years the accountant has dealt with the recovery of overhead in a traditional manner following the procedure outlined earlier.

The business has three major producing cost centres; Machining, Finishing and Packing.

The process of allocation and apportionment for period end March 2000 had been complete and the predetermined figures were:

Cost centre

Machining

Finishing

Packing

Overhead

£70,000

£27,500

£15,000

Machine hours

13,000

6,250

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