The short-term variable costs should be identified to products using volume related cost drivers such as direct labour hour, direct material cost, machine hours etc. Kalpan and Cooper claimed that volume related cost drivers are inappropriate for tracing long-term variable costs to products because they are driven by complexity and variety and not by volume and the key to understanding what causes (drivers) overhead costs in transactions undertaken by support departments costs and factory overheads to product lines under ABC system is shown in the following figure:
Steps to Develop ABC System:
The steps required to develop an ABC system are as follows:
1. Identify the main activities performed in the organization, such as manufacturing, assembly etc., as well as support activities, including purchasing, packing and dispatching.
2. Identify the factors which influence the cost of each activity- the cost drivers.
3. Collect accurate data on direct labour, material and overhead costs.
4. Establishing the demands made by particular products on activities, using the cost drivers as a measure of demand.
5. Trace the cost of activities to products according to a product’s demand for each activity.
Important characteristics of ABC are noted below:
1. Simple traditional distinction made between fixed cost and variable cost is not enough guide to provide quality information to design a cost system.
2. The more appropriate distinction between cost behaviour patterns are volume (scale) related, diversity (scope) related, events (decisions) related and time related.
3. Cost drivers need to be identified. A cost driver is a structural determinant of cost related activity. The logic behind is that cost drivers dictate the cost behaviour pattern. In tracing overhead cost to product, a cost behaviour pattern must be understood so that appropriate cost driver could be identified.