Activity based costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity. Activity based costing is a subset of activity-based management.
Activity based costing is used to determine product costs and for internal decision-making and for managing activities. Traditional Absorption costing is for external financial reporting.Activity-based costing is a suitable and appropriate method for companies with multiple products or services who are having problem of inaccurate costing information and need to know which products are really profitable and which are the one that is making loss. For these companies the effort required to successfully implement activity based costing is worth the time and resources.
Activity based costing can identify high overhead costs per unit and find ways to reduce the costs, avoid decreases in head counts due to inaccurate allocation of costs, and measure profitability with higher accuracy than traditional costing that uses direct-labor hours as the only cost driver. The way it works is first major activities are identified in the process system. Next cost pools are created for groups of activities that can be allocated together. Following this cost drivers is identified. The numbers of cost drivers used vary depending on the balance between accuracy and complexity.After determining the cost drivers, rates are calculated.
The rates are then applied to the respective cost drivers for each product or service that is being considered. Dividing the total cost for the product by the total product units then derives the overhead cost per unit. Overall, activity based costing has more advantages compare to traditional costing, but this method is only suitable for big company. As this method is costly and need substantial resources.
By using activity based costing, it is easier to maintain low cost but high profit.Although this method has many advantages, if the user does not have enough experience, this will not a very suitable method as this is easy to be misinterpreted. Why is Activity-Based Costing Developed Traditional costing had added a high amount of expenses into the indirect cost. However, as the percentages of indirect or overhead costs rose, traditional costing become more inaccurate, because all products did not cause indirect costs equally. For example, product A may take more time in one expensive machine than product B. ut since the amount of direct labor materials might be the same, additional cost for use of the machine is not being recognized.
When multiple products share common costs, there is a danger of one product subsidizing another. By using this system, managers were making decision based on inaccurate data especially where there are multiple products. Activity-based costing was first clearly defined in 1987 by Robert S. Kaplan and W. Bruns. Cooper and Kaplan described ABC as an approach to solve the problems of traditional cost management system.
For example, increased automation has reduced labor, which is a direct cost, but has increased depreciation, which is an indirect cost. These traditional costing systems are often unable to determine accurately the actual costs of production and of the costs of related services. Instead of using high amount to allocate costs, Activity Based Costing seeks to identify cause and affect relationships to objectively assign costs. Once costs of the activities have been identified, the cost of each activity is attributed to each product to the extent that the product uses the activity.In this way activity based costing often identifies areas of high overhead costs per unit and so directs attention to finding ways to reduce the costs or to charge more for costly products.
Activity-based costing records the costs that traditional cost accounting does not do. Activity Based Costing provides this improved understanding by first tracing operating costs to the activities performed within the organization. Secondly, these activities are traced to the products, services, or customers for whom the activity is performed. In conclusion, ABC stands out by breaking down the costs into a very detailed level.This information will give management a very clear picture of which processes come with high costs but little value and how to improve the process or to eliminate the process entirely.
This method is suitable for use when there is high overhead, complex product and in very competitive market. Difference between Activity-Based Costing and Traditional Absorption approach Activity based costing systems accumulate costs into activity cost pools. These are designed to match to the major activities or business processes. The costs in each cost pools are largely caused by a single factor called the cost driver.Whereas in traditional costing, systems accumulate costs into facility-wide or department cost pools. The costs in each cost pool are different.
There are many costs of different processes, which are not caused by a single factor. Activity based costing systems allocate costs to products, services, and other cost objects from the activity cost pools using allocation bases corresponding to cost drivers of activities cost. Whereas in traditional costing, systems allocate to products using volume-based allocation bases, for example, units, direct labor, machine hours or revenue dollars.In terms of hierarchy of costs, activity based costing allows for different costs within the organizations by recognizing that the number of units produced does not cause some costs. In traditional costing, all the costs that are driven by the volume of product or service are estimated.
Activity based costing focuses on estimating the costs of many cost objects of interest such as units, batches, product lines, business processes, customers, and suppliers. In traditional costing, focuses on estimating the cost of a single cost object.Because of the ability to align allocation bases with cost drivers, activity based costing provides more accurate information to support managerial decisions. Traditional costing, may lead to overcosting and undercosting problems, as this system cannot align allocation bases with cost drivers.
Activity based costing is more costly to maintain and implement compare to traditional costing, which is inexpensive. The differences from traditional absorption costing can have a great impact in pricing and profitability. Advantages and Limitation of Activity-Based Costing Preparing plan and budgetsThe primary advantage of activity-based budgets is that costs can be more accurately associated with activities, making the planning process more precise and corrections more effective. Companies using this approach report benefits including * Establishing more realistic budgets * Improved accuracy in identifying resource needs * Better linking of costs to outputs * More precise allocation of costs to staff responsibilities By using Activity-Based Costing, the cost shown is very detailed and obvious. Activity based costing is differs from traditional accounting system.Therefore, this cannot be used for external financial reports.
Companies who use this system will have two costing system. Both traditional accounting system and activity based costing should be provided. As the traditional system is accordance with Generally Accepted Accounting Principles (GAAP) therefore this is used for external financial reports. The activity based costing will be used for internal decision making and managing activities. The other disadvantages of activity based costing are that the method of implementation is complex and time consuming.
The process of data collection and data entry requires substantial resources. Therefore, it is costly to maintain. One of the basic problems in Activity based costing is the difficulty of implementation. Identifying activities or processes to be allocated properly is troublesome and takes a lot of effort. The process of data collection and data entry requires substantial resources.
Therefore, it is costly to maintain. It requires that processes be appropriately planned throughout the organization. Just as anything else, Activity-Based Costing is not an answer or solution for all problems.It is an operational strategy that needs to be carefully reviewed for applicability.
The best way to approach the situation is to first think through a facility and its processes, identify the opportunities, and then develop a thought of a solution. Monitoring and Controlling The major advantage of activity based costing is the ability to estimate the cost of individual products and services precisely. By transferring overhead costs to individual units of products or services, ABC helps identify inefficient or non-profitable products or activities that eat into the profitability of efficient processes or highly profitable products.Making possible appropriate pricing by reducing prices of products that use less activity resources and increase prices of products that consume more of the firm’s activity resources. This system also helps organizations provide value added services to existing products on actual cost incurred basis. By eliminating unprofitable items from the product line and the cost of maintaining non-remunerative activities, thereby increasing profitability without increasing prices, a valuable option in recessionary times.
It allows allocation of resources to profitable items or items that use less resources.It ensures compatibility with performance management scorecards by revealing per person contribution to the product cost, and hence, profits. By exposing waste and inefficiency that contributes to boosting productivity. Activity cased costing highlights non-remunerative distribution channels allowing the management to adopt alternative marketing strategies or close down the channel for a more profitable one. Too much attention to detail and control might obscure the bigger picture or make the firm lose sight of strategic objectives in a quest for small savings, making the firm “penny wise and pound foolish.
For instance, Activity Based Costing might identify one distribution channel as non-remunerative, or an inspection as non-value adding. Such channeling or processes might be non-profitable, but placed in the first place to achieve some other strategic objectives. Decision Making Managers use cost accounting to support decision-making to cut a company's costs and improve profitability. Traditional costing sometimes added too high amount of indirect costs.
This will causes in false decision as managers are making decision based on inaccurate information.Activity based costing gathers information from the processes it can be used to identify what should be done and how to allocate resources most productively. Activity based costing can therefore give managers the ability to match the resource needs with the available capacity as closely as possible, and hence improving productivity. From this we understand that traditional costing systems gives no decision support in allocating capacity to match resource needs.This can lead to cost inefficient organizations and poor profitability. Since activity based osting provides accurate value, it highlights non-remunerative distribution channels allowing the management to change alternative marketing strategies or close down the channel for a more profitable one.
As it is a tool for a more accurate way of allocating fixed costs into product, these fixed costs do not vary according to each month's production volume. For example, an elimination of one product would not eliminate the overhead or even direct labor cost assigned to it. ABC better identifies product costing in the long run, but may not be too helpful in day-to-day decision-making.
