Activity Based Costing

What is Activity Based Costing (ABC)?

Activity Based Costing (ABC) is a 2 step method of costing whereby costs are first allocated to ‘identified activities’ of a business and then from activities they are assigned to products or services. In other words, the costing of products or services is based on activities performed to manufacture/render a particular product or service. If for manufacturing a product A, activity X is not used, the cost for that activity would not be allocated to that product A. It is a much refined method of costing a product that suits to current industry environment.

Benefits of Using ABC Costing

Broad Averages

Traditionally, costing exercises have relied a lot on broad averages. That is where; the ABC had to take birth to refine the system of costing from the curses like averaging as far as possible.

Over / Under Costing

Over and under costing was a result of such method of averaging and loosely defined cause and effect relation between the cost and the product. By introduction of activity in between costs and products, the relation between cost – activities – products are clearer.

Activity Based Costing

Product Cross-Subsidization

The products which are victims of over costing automatically allow other product’s under costing and vice versa. ABC costing can help eradicate the problem if the implementation of activity based costing system is appropriate.

Complications of Processes

With the growth and development of industry and business, the complications in the processes of manufacturing or providing services have increased significantly. An average product manufacturing requires more than 3 to 4 processes. To deal complications in costing created due to processes, ABC is a blessing in disguise.

Product Customizations

Previously, there was less number of options for a product but now there are a lot of variations in products due to colors, design, durability, weight etc. All of these are manufactured in the same setup. This again calls for a refined system of costing so that one can price the products accordingly.

Increase in Indirect Costs

There has been a significant increase in indirect costs with the advent of technology. Against the only cost i.e. labor, there are fixed costs of machinery replacing the labor cost. Technical hitches due to the introduction of sophisticated machineries have increased.

Competition

Because of heavy competition, every business looking out for streamlining their cost structure and manufacture products that suit their manufacturing and organizational setup.

Cost Saving Opportunities

It is easy to find cost saving opportunities in this kind of costing system.

Product Mix Optimization

Product mix problems can be better addressed when the system like ABC Costing is in place.

Disadvantages of Using ABC Costing

Need Specialized Knowledge

Knowledge of costing, cost accounting, costing terms such as cost drivers, allocation, cause and effect relation, etc is a must. It is not a job of a layman.

Deep Understanding of the Organizational Process

The people employing this method of costing require vast experience in the related industry or in-depth understanding of the products and processes.

Heavy use of Information Technology

It would not be possible without the use of information technology. It needs to collect a lot of data, convert them into information, and analyze the information to extract reasons for implementing a particular decision.

Time Consuming

Since there are a lot of steps and groundwork required to come out with a costing based on this system, it is quite a time to consume.

We have understood what Activity based costing is and also understood its benefits and disadvantages. We can encounter that the benefits definitely overcome the disadvantages and therefore this system is worth for every organization. We know that ‘Cost of costing should not be more than the benefits we derive from costing’. Though it is a very useful method, it may not be as useful for trading firms compared to manufacturing firms. Therefore, before the implementing such a system, benefits to the individual organization should carefully understood and then take a forward decision.

References:

Charles T. Horgren, Srikant M. Datar, George Foster, Madhav V. Rajan & Christopher Ittner, Cost Accounting: A Managerial Emphasis(Thirteenth edition).Pearson Education, Inc.

Last updated on : December 9th, 2017

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2 Comments

  1. john

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