In the past, the vast majority of departments used direct labor hours as the only cost driver for applying costs to products. But direct labor hours is not a very good measure of the cause of costs in modern, highly automated departments. Labor-related costs in an automated system may be only 5 percent to 10 percent of the total manufacturing costs and often are not related to the causes of most manufacturing overhead costs. Therefore, many companies are beginning to use machine-hours as their cost-allocation base. However, some managers in modern manufacturing firms and automated service companies believe it is inappropriate to allocate all costs based on measures of volume. Using direct labor hours or cost-or even machine hours-as the only cost driver seldom meets the cause/effect criterion desired in cost allocation. If many costs are caused by non volume-based cost drivers, Activity Based Costing (ABC) should be considered
Activity Based Costing (ABC) is an economic model that identifies the cost pools or activity centers in an organization and assigns costs to cost drivers based on the number of each activity used. It identifies activities in an organization and assigns the cost of each activity resource to all products and services according to the actual consumption by each: it assigns more indirect costs (overhead) into direct costs. In this way, an organization can precisely estimate the cost of individual products and services so they can identify and eliminate those that are unprofitable and lower the prices of those that are overpriced.
In a business organization, the ABC methodology assigns an organization’s resource costs through activities to the products and services provided to its customers. It is generally used as a tool for understanding product and customer cost and profitability. As such, ABC has predominantly been used to support strategic decisions such as pricing, outsourcing, identification and measurement of process improvement initiatives.
Activity based costing (ABC) systems first accumulate overhead costs for each of the activities of an organization, and then assign the costs of activities to the products, services, or other cost objects that caused that activity. To establish a cause-effect relationship between an activity and a cost object, cost drivers are identified for each activity.
Cost-driver activity is measured by the number of transactions involved in the activity. Because transactions are often used for assigning costs of activities to cost objects, activity-based costing is also called transaction-based accounting or transaction costing.
Cost drivers are related to the activities, they occur on several levels:
- Unit level drivers which assume the increase of the inputs for every unit that is being produced.
- Batch level drivers which assume the variation of the inputs for every batch that is being produced.
- Product level drivers which assume the necessity of the inputs to support the production of each different type of product.
- Facility level drivers are the drivers which are related to the facility’s manufacturing process. Users of the ABC system will need to identify the activities which generate cost and then match the activities to the level bases used to assign costs to the products.
While using the ABC system, the activities which generate cost must be determined and then should be matched to the level drivers used to assign costs to the products. The implementation of the ABC system has the following steps:
- Identifying the activities such as engineering, machining, inspection, etc.
- Determining the activity costs
- Determining the cost drivers such as machining hours, number of setups, engineering hours, etc.
- Collecting the activity data
- Computing the product cost
Advantages of Activity Based Costing
Traditional costing methods divide costs into product costs and period costs. The period costs include selling, general, and administrative items and are charged against income in the period incurred. Product costs are the familiar direct materials, direct labor, and factory overhead, these costs are traced/allocated to production under both job and process costing techniques. However, some managers reject this methodology as conceptually flawed. For example, it can be argued that the cost of a finished product should include not only the cost of direct materials, but also a portion of the administrative cost necessary to buy the raw materials (e.g., many companies have a separate administrative unit in charge of all purchasing activity, like writing specifications, obtaining bids, issuing purchase orders, and so forth). Conversely, the cost of a plant security guard is part of factory overhead, but some managers fail to see a correlation between that activity and a finished product; after all, the guard will be needed no matter how many units are produced.
Activity based costing attempts to overcome the perceived deficiencies in traditional costing methods by more closely aligning activities with products. This requires abandoning the traditional division between product and period costs, instead seeking to find a more direct linkage between activities, costs, and products. This means that products will be charged with the costs of manufacturing and non-manufacturing activities. It also means that some manufacturing costs will not be attached to products. This is quite a departure from traditional thought.
Another benefit of ABC is that a product is only charged with the cost of capacity utilized. Idle capacity is isolated and not charged to a product or service. Under traditional approaches, some idle capacity may be incorporated into the overhead allocation rates, thereby potentially distorting the cost of specific output. This may limit the ability of managers to truly understand and identify the best business decisions about product pricing and targeted production levels.
Disadvantages of Activity Based Costing
One limitation of ABC is that external reporting must be based on traditional absorption costing methods. Absorption costing requires the traditional division between product costs and period costs, with inventory absorbing all of the manufacturing costs and none of the period costs. As a result, ABC may produce results that differ from those required under generally accepted accounting principles (GAAP). Therefore, ABC is usually viewed as supplemental in nature. It is used for internal management decision making, but it may not be suitable for public reporting (note: when the aggregate financial statement results do not differ materially between ABC and other methods, ABC can be used for both internal and external purposes).
The fact that ABC is not GAAP usually means that a company that wishes to benefit from ABC must develop two costing systems — one for external reporting and one for internal management. Some companies feel they have enough to do without working through two costing methods! Another disadvantage of ABC is that it is usually more involved than other approaches. Rather than applying all factory overhead on some simple basis such as labor hours, it requires the development of numerous cost pools that must be individually allocated. In other words, ABC is a more intensive technique, and the costs to implement it may not be worth the trouble.
The Reality of Activity Based Costing
Despite the limitations of ABC, many companies utilize the method. A quick internet search will reveal millions of references to the approach, including various management consultant groups praising its merits. As you might suspect, many important business decisions about the fate of a product are based on assessment of profitability, and profitability boils down to comparing sales price to cost. Because the sales price is pretty well set, the “decision” about how to determine a product’s cost is obviously quite significant in assessing the bottom-line profitability for an individual product or service.
Now, for a single-product company with fairly stable inventory levels, this is much to do about nothing. Traditional and ABC methods will get to about the same end point. But, for multi-product/service firms, the arbitrary allocation of costs can pretty much “make or break” the perceived profitability of each product or service. As companies have grown larger and more diverse in output, there has been an accompanying concern about how costing occurs. Arguably, product diversification has been a major contributing factor into the management accountant’s pursuit of alternative costing devices like ABC.
Another driver of ABC-type approaches has been the advent of computer technology. Before modern information systems, it was very expensive to manipulate data. Most firms were perfectly content to live with simple approaches that allocated factory overhead on a single basis. The ease with which data can be managed under a sophisticated information system greatly reduces the cost and error rate associated with ABC. It is not surprising that the method’s popularity is inversely related to data processing costs.
Thus, Activity Based costing method scores over the traditional methods as it gives a more realistic absorption of indirect cost as it uses the activity as base which is major contributor to the costs concerned unlike the traditional cost which uses a single base which may or may not have any relation with the costs incurred for a particular activity. Traditional method assumes that all costs incurred in proportion to the machine hour or labor hour which tends to give misappropriate allocation of cost. In traditional method, it might happen that a particular Product does not consume a particular activity, but it costs might get appropriated over it. In ABC it will not happen. Thus, ABC is better approach as it gives proper allocation of costs which in result leads to better decision making by the management.