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Traditionally, manufacturing companies classified the manufacturing costs to be allocated to the products into (a) direct materials. (b) direct labour and (c) indirect manufacturing costs. In the present day context, characterised by intensive global competition, large scale automation of manufacturing process, computerization and product diversification to cater to the changing consumer tastes and preferences has forced companies to refine their costing systems to provide better measurement of the overhead costs used by different cost objects. Accordingly, manufacturing costs are classified in to three broad categories as under:
1. Direct cost: As many total costs relating to cost objects as feasible are classified into direct cost. The objective is to trace as many costs as possible in to direct and to reduce the amount of costs classified into indirect because the greater the proportion of direct costs the greater the accuracy of the cost system.
2. Indirect cost pools: Increase the number of indirect cost pools so that each of these pools is more homogeneous. In a homogeneous cost pool, all the costs will have the same cause-and-effect relationship with the cost allocation base.
3. Use cost-and-effect criterion for identifying the cost allocation base for each indirect cost pool.
The change in the classification of manufacturing costs as above has lead to the development of Activity Based Costing (ABC). Activity Based Costing refines a costing system by focusing on individual activities as the fundamental cost objects. An activity is an event, task or unit of work with a specified purpose as for example, designing, set up, etc. ABC system calculates the costs of individual activities and assigns costs to cost objects such as products or services on the basis of the activities consumed to produce the product or provide the service.
