Inception of Activity Based Costing

Activity-based costing enables reasonably accurate allocation of overheads.
The activities in an organization are spread across the organizational processes and value chain. The traditional methods of costing faced severe criticism due to inaccuracies. While it is easy to apportion direct costs to individual products in a company with a wide product mix, it is difficult to apportion indirect costs to the products. Therefore traditional methods sought estimates to assign overhead costs. In the earlier paradigm, Labor costs constituted a substantial part of the total cost of manufacture. Therefore direct labour costs were used to assign the overhead costs to various jobs relating to the manufacture of products. But today there has been a paradigm shift with technology pervading the value chain replacing a large chunk of Labor by automated processes. The proportion of materials cost in many industries has augmented with the dwindling of labour costs. Similarly increasing automation and shrinking life span of machines have led to the increase in capital costs. There has also been a concomitant increase in overhead costs pertaining to information technology and depreciation of expensive plant and machinery, maintenance and utilities in most industries. In the new paradigm, the companies found direct labour as the basis for apportionment of overheads inaccurate to capture the costs for the products. The companies, therefore, used machine hours instead of direct Labor for apportioning the overhead costs.
With the growing complexity of manufacturing processes, neither direct Labor nor machine hour would suffice as bases for allocation of overhead costs to processes of products. Therefore the new circumstances demanded multiple bases for allocation of overhead costs.

These factors paved the way for the evolution of activity-based costing, which uses multiple bases for overhead allocation.nbsp.nbsp.