Activity based costing (ABC) is a costing model that recognizes activities in a company and assigns the cost of each activity resource to all products and services according to the actual use by each: it assigns more indirect costs overhead into direct costs. In this method a company can exactly estimate the cost of its individual products and services for the purposes of recognizing and reducing those which are unbeneficial and lowering the prices of those which are overpriced. In a business organization, the Activity based costing method assigns an organization’s resource costs through activities to the products and services given to its consumers. It is commonly used as a device for understanding product and consumer cost and profitability. As such, Activity based costing has predominantly been utilized to support strategic decisions such as pricing, outsourcing and recognition and measurement of procedure enhancement initiatives.
Activity based costing is basically a change in accent. People perform activities and activities use resources. Thus, by controlling activities the manager is making sure that costs are controlled at their source. A wise manager will not focus on how to estimate product costs, but will focus more on why the costs were there in the first place. When intending an activity based costing system this should be utilized as a departure point.
Advantages of Activity Based Costing System
- The first and most significant benefit is the accuracy in the procedure of costing with regards to the product line, the consumers of the product, the stock-keeping units employed by the administration and the channel and group which streamline the flow of the product from the maker to the consumer.
- This system better helps in the procedure of understanding the concept of overhead costs i.e. the distribution of common business resources as they are utilized by particular product lines and their association to particular cost driver.
- The system is simple to interpret and understand is it is available, useable and specifically implement capable across all norms of business set-ups.
- This procedure consumes unitary cost, or marginal cost as the calculation base in comparison to the conventional cost accounting techniques which employ total cost.
- The system works extremely well will quality enhancement and up gradation programs e.g. Six Sigma.
- This system is specifically useful in recognizing and ear-marking some of the matters business activities which are a stress or burden on the business i.e. wasteful or non value adding services.
- The system also serves exceptionally with performance administration systems which are used by most human resource departments in modern businesses.
- This procedure permits firms to implement costing policies across another diagonal of the company as business procedures, supply chains and value addition channels are capably and optimally analyzed in this procedure.
- This system mimics the actual business procedure as the appropriation of common pool resources takes place in the same way as common resources are utilized in the business.
- This system aids in the procedure of benchmarking which is a vital part of the quality control procedure.
Disadvantages of Activity Based Costing System
- Data collection procedure for this system is very time consuming.
- The capital expense on the activity based system and its subsequent running costs can be a road block for companies.
- The system is very apparent which some managers would not authorize of as they would like to keep some things out of the view of the owners of the firm.
- ABC Costing System is very costly to implement and maintain in a manufacturing and serving departments. Data concerning numerous activity measures must be collected, checked, and entered into the system.
- ABC costing systems produces the reports that are different from the profit and loss reports produced through traditional costing systems.
- As most of the companies are using traditional costing systems, so because of the difference in the costing basis the costing and financial reports of the two companies of the same industry could not be compared for performance evaluation purposes.
- Adaptability of ABC Costing System is not suitable for all kind of companies because small companies have not many resources to adapt it and have too many activities but size of transactions is too low.
- Data Produced through ABC Costing System can easily misinterpret and can lead towards wrong decisions. So manager should use the data produced through ABC Costing System with extreme care and should assign the costs that are relevant to the products, customers and should not consider the other cost objects that are irrelevant.
- ABC costing system does not comply with the GAAP and a company has to produce its reports for internal and external purposes by using traditional and ABC costing system both at a time.
- In ABC costing system costs are allocated on the base of cost drivers and activities undertaken to manufacture the product, definitely, it provides the accurate and proper allocation of the costs to the products but there is a danger of over or under costing of the products when irrelevant cost drivers or activities are assigned to the products or services produced.
Limitations of Applying Activity Based Costing
Even in ABC, some overhead costs are complex to assign to products and consumers, such as the chief executive’s pay. These expenses are termed ‘business sustaining’ and are not assigned to products and consumers because there is no meaningful way. This lump of unallocated overhead costs must nonetheless be met by participations from each of the products, but it is not as large as the overhead costs before Activity-based costing is used. Although some may argue that costs undetectable to activities should be “randomly allocated” to products, it is significant to understand that the only purpose of Activity-based costing is to provide information to administration. Thus, there is no reason to assign any cost in a random manner.
Activity-based costing is considered a comparatively expensive accounting method, and whether its good value is questioned. Activity-based costing has been established to be a very high-cost accounting technology. Installing an Activity-based costing system is technically difficult, requiring talented workers and a substantial amount of time and money. Lean accounting methods have been developed in recent years to provide relevant and thorough accounting, control, and dimension systems without the difficult and highly wasteful techniques of Activity based costing. Lean Accounting takes an opposite direction from Activity-based costing by working to reduce cost allocations rather than find difficult ways of distribution. While lean accounting is mostly utilized within lean manufacturing, the approach has proven helpful in several other areas containing healthcare, construction, financial services, regime, and other businesses.
In conclusion, it is significant to keep in mind that the goals should be met at the minimum cost and difficulty in order to intend an activity based costing system. To be successful, the last activity based costing system should give the right type of information at the right level of detail. In addition to this the design of the system should be as simple as feasible without being too easy since it may report inaccurate costs if it is too easy. The answer is to strike a balance between simplicity and difficulty. In addition to this, performance calculates should be recognized at procedure level and for key activities. They should be utilized to monitor and assess activities or procedures and must be utilized to promote consistent enhancement. This should be done without unnecessarily complicating the design of the system.