LO 6.3How are costs allocated in an ABC system?

Step 1: Identify the activities that generate costs

Step 2: Now we will find cost pools and their relevant cost drivers

Step 3: Assign the cost of each activity (cost pool) on a fair basis which is cost drivers

cost assigned to total products of A = (cost pool/total units of relevant cost driver consumed) * units of cost driver consumed by total # of Products A

Step 4: Divide the Answer from the step 3 by total units of product A produced to calculate unit cost

Step 5: Add prime cost per unit to it to calculate total unit cost of the product A

Explanation:

The costs in the ABC system are allocated to unit product on more fair basis than the tradition absorption costing which only assume one fair basis for allocation of overhead costs. ABC critisises traditional costing technique for using only one basis for absortion of Overheads.

Suppose both Mr. A and Mr. B drank 5 glasses of juices. Each glass of juice costs $4. According to the Traditional absorption costing technique each individual must pay:

(5 Juices/2) * $4=$10

But ABC says its unfair, use a more appropriate basis for cost allocation. So upon investigating we came to know that Mr. A drank 3 glasses of juice and Mr. B drank 2 glasses of juice. So Mr. A must pay $12 (3*$4) and Mr. B must pay $8 (2*$4). This is more appropriate or fair basis of absorbing the overhead cost to each individual and is Activity Based Costing.