Question

Why is it important to classify costs into a cost hierarchy when it applies to the ABC metbod?

Answer 1

Under activity based costing, the costs are first allocated to activities and then to the products. So activity based costing classifies same nature of costs to one group of costs called as cost pools. As business incurs various indirect expenses it results in multiple cost pools. Each cost pool differs from the other cost pool in terms of 'cost allocation basis' (or cost driver).

That means, each cost pool has different cost allocation basis. For example, in a manufacturing process there are three activity cost pools 'assembling', 'setting up' and 'testing'. These different activity cost pools got three different cost allocation basis or cost drivers - 'number of parts assembled' , 'number of set ups' and ' number of tests' respectively.

Now the products which have underwent processing under different activities in different ways can't be allocated based on number of units produced.

As allocation basis are not the same it is important to classify costs into cost hierarchy. It is not accurate to allocate on number of units produced.