In recent years there has been criticism of the traditional system of costing for overheads ( Kaplan & Cooper ). Traditional cost systems were designed when:

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  • direct costs were the dominant factory costs;
  • overhead costs were relatively small;
  • information processing costs were high;
  • there was a lack of intense global competition;
  • a limited range of products was produced.

 

Traditional product costing measures accurately volume-related resources eg. direct costs but they fail to measure the way products consume non-volume related activities eg. support services like material handling, set-up costs, inspection costs. Resources are used up when these activities are triggered by production. It is the products which cause these activities to arise and ABC attempts to trace the consumption of these activities by the various products. Products which demand a lot of activities and resources are allocated an appropriate share of the overheads. For example, a new product will probably be low volume initially, requiring a lot of machine set-ups, quality testing etc. so it should bear the overheads it is causing to be created.

 

Example: Two products A and B are produced ( 5000 units of A and 45000 units of B). Each product requires the same number of machine/direct labour hours.

Number of set-ups:   A = 10       B = 5

The cost of set-ups is £1.2m.

 

Absorption costing:

 

Product A = £120,000 (10% of £1.2m.) / 5000units = £24 per unit

Product B = £1.08m (90% of £1.2m.) / 45,000 units = £24 per unit

 

ABC system:

 

       Product A = £800,000 (10/15 x £1.2m) / 5,000 units = £160 per unit

       Product B = £400,000 (5/15 x £1.2m) / 45,000 units = £8.89 per unit

 

Since product A, the low volume product is responsible for the greater share of the set-up costs it is only right that it attracts most of this overhead. It is the number of set-ups that is the cost driver. The traditional costing system tends to overcost high volume products and undercost low-volume but complex products.

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