The reason why Activity Cost is evolved?

Traditional cost accumulation process of absorption costing was established in a time when most organizations produced a small range of products. That’s why products experienced similar operations and consumed similar proportions of overheads. And overhead costs were only a very small portion of total costs, direct labor and direct material costs were largest proportion of the costs. More accurate systems and reliable overhead allocation have been relatively small. In addition, information processing costs were high.

In recent years, there has been a sensational fall in the costs of processing information. And, with the initiation of advanced manufacturing technology (AMT), overheads are likely to be far more important and in fact direct labor may account for as low as 5% of a product's cost. It therefore now looks difficult to justify the consumption of direct labor or direct material as the basis for absorbing overheads or to consider that errors made in attributing overheads will not be substantial.

Many resources are used in non-volume related support activities, (which have increased due to AMT) such as machine setup, production scheduling, inspection and data processing. These support activities assist the efficient manufacture of a large range of products and are not, in general, affected by variations in production volume. They incline to fluctuate in the long term according to the range and complexity of the products manufactured rather than the volume of output. 

Traditional costing systems, which assume that all products consume all resources in proportion to their production volumes, tend to allocate too great a proportion of overheads to high volume products and too small a proportion of overheads to low volume products. Activity based costing (ABC) attempts to overcome this problem .
Share This
Previous Post
Next Post