Activity Based Costing (ABC)
Activity Based Costing (ABC) Meaning |
An activity-based costing method identifies overhead and indirect costs associated with related products and services.
Unlike traditional costing methods, this method recognizes the relationship between costs, overhead activities, and manufactured products.
There are, however, some indirect costs that are difficult to assign to a product, such as management and office staff salaries.
Manufacturing companies primarily use activity-based costing (ABC) since it enhances the reliability of cost data, resulting in nearly true costs and a better classification of costs.
By allocating manufacturing overhead costs on the basis of product activity rather than machine hours, activity-based costing (ABC) provides a more logical method of allocating manufacturing costs.
In activity-based costing, overheads are first assigned to the activities that generate them. Costs for those activities are then assigned only to products that require them.
Advantages/Pros of Activity Based Costing (ABC) |
a) Accurate and Reliable Product Cost:
By focusing on the cause and effect relationship in cost incurrence, ABC brings accuracy and reliability to product cost determination.
Costs are caused by activities, not products, and products are consumed by activities. ABC provides more realistic cost information in advanced manufacturing environments and technologies where support functions make up a large share of total costs.
When there is a greater variety of products manufactured, such as low-volume products and high-volume products, ABC produces reliable and correct product cost data.
By using arbitrary apportionment and absorption methods, the traditional costing system may lead to errors and approximations in product cost determination.
b) Information about Real Nature of Cost Behaviour:
ABC evaluates the real nature of costs and provides insights into activities that do not add value to the product and help reduce costs.
By exercising more control over the activities that contributed to the fixed overhead costs, managers can control many fixed overhead costs.
Due to the increased visibility and clarity of fixed overhead costs in relation to activities, this is now possible.
c) Cost Object Activity Tracing:
In addition to product volume, ABC uses many transaction-based cost drivers. To trace more overheads to the products, ABC examines all activities inside and outside the factory.
d) Overhead Cost Tracing:
Aside from product costs, ABC traces costs to areas of managerial responsibility, processes, customers, departments.
Using activity-based costing, you can allocate the necessary budget in each area rather than assigning an equal value to each product.
Depending on their indirect costs, some products may be more expensive to produce. It can also help identify costs associated with more than one manufacturing product pool, thereby maximizing resource utilization.
e) Improved Decision Making:
A better understanding of product costs allows managers to make better decisions. Due to the availability of more accurate data about product costs, ABC plays a useful role in fixing selling prices of products.
f) Management of costs:
It is very useful for managing cost drivers and evaluating performance of responsibility centers to have ABC provide cost driver rates and transaction volume information.
It is advantageous to use cost driver rates when designing new products or updating existing products as they provide insight into the overhead costs that will likely be applied when costing the product.
g) Reduction of costs and utilization of excess capacity:
ABC can be used to identify cost drivers in a variety of ways through the pooling of activity costs. These include identifying spare capacity and fostering cost reduction through a comparison of current and proposed ABC resources.
Using the resource relationships identified by ABC, future resource requirements can be projected based on activity-based budgeting.
h) Service Industry Benefits:
Organizations that provide services, like banks, hospitals, and government agencies, have different characteristics than those that manufacture products.
Organizations that provide services have almost no direct costs, the majority of their expenses are overhead, and they do not keep stocks of services because the services are consumed at the time of production.
ABC has the potential to improve decision making and cost management in these organizations compared to traditional costing.
Disadvantages/Cons of Activity Based Costing (ABC) |
a) ABC costing can be a time-consuming process:
There is no doubt that activity-based costing can be a time-consuming process. It is necessary for team members to manually determine the costs associated with each product instead of calculating total costs and dividing them equally across all products.
There is a process that has to be followed in order to divide the products into different pools.
Depending on the size of the business, there may be a need to assign a team to this particular task, but the company may also choose to outsource it.
It may be more convenient to use this method since it usually requires a team of employees at the management level to conduct this process.
There is also the added advantage that when you outsource this task to a team that specializes in activity-based costing, the team is usually already familiar with the software that is involved in the process.
b) ABC costing is Expensive and Complex:
ABC can be more complex than traditional product costing systems because of its numerous cost pools and multiple cost drivers. ABC systems can be expensive to manage.
c) Driver selection:
ABC system implementation faces some challenges, such as selecting cost drivers, assigning common costs, and varying cost driver rates.
d) Disadvantages to Smaller Firms:
The utility of ABC varies depending on the organization, for example, a large manufacturing company may find ABC more useful than a smaller business.
Furthermore, firms that rely on cost-plus pricing may benefit from ABC as it provides accurate product costs.
ABC may not be preferred by firms that use market-based pricing. Different firms apply ABC based on their technology and manufacturing environment.
Using activity-based costing may not be as efficient for smaller companies with small overhead costs.
Furthermore, they are more likely to use market-based costs when calculating data, which is not always aligned with activity-based costing.
In the manufacturing industry, activity-based costing is most common. Other industries are also benefiting from it.
e) Difficulties with measurement:
ABC systems are primarily limited by the measurements they require to be implemented. Using ABC systems, management must estimate the costs of activity pools and identify and measure cost drivers for cost allocation.
Calculations are required even for basic ABC systems to determine the cost of products and services. It is expensive to conduct these measurements. It is also necessary to update activity cost rates on a regular basis.
You may not always have access to the information you need depending on the manufacturing system or program you use.
In order to collect the data you need, you may need to use specific software. In addition, the reports you use when collecting this type of data do not always follow traditional accounting principles, making things more difficult for some teams to track.
Activity-based costing may require training for all production and manufacturing teams. When they do, however, the process typically becomes easier for all parties involved.
Having the right resources and team members can make it easier to gather the data you need.
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MBA,BBA.
I am Smirti Bam, an enthusiastic edu blogger with a passion for sharing insights into the dynamic world of business and management through this website.
I hold a MBA degree from Presidential Business School, Kathmandu, and a BBA degree with a specialization in Finance from Apex College,
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