What is Activity Based Costing? Advantages, Disadvantage, Process

What is Activity Based Costing?

Activity Based Costing is cost attribution to cost units on the basis of benefits received from indirect activities i.e., ordering, setting-up, assuring quality etc.

Reasons for Introduction of ABC

There are some important reasons for introduction of ABC, such as:

  1. Traditional costing fails to capture cause and effect relationship.

  2. Traditional costing systems are driven by the need to value stocks rather than to provide meaningful product cost.

  3. Market place is very competitive.

  4. Traditional costing often fails to highlight inter-relationship among activities in different departments.

  5. Direct labour has shrunk as a percentage of total cost for majority of manufacturing companies. Still it is most common basis of over-loading overheads to products.

  6. Complexity has increased and product ranges are wider.

  7. Product cycles are shorter and demand for quality is higher.

Thus by emphasizing on activities, ABC ties to ascertain the factors that cause each major activity, the cost of such activities, and the relationship between activities and products produced.

The relationship between activities and products has been shown in the following figure:

Steps of ABC Process

Steps of ABC Process

  • Identify the main activities in the organization, like material handling, purchasing, dispatch, assembly etc.

  • Identify the factors, which determine the costs of an activity. These are known as cost drivers like numbers of purchase order, numbers of orders delivered, no. of set-ups etc.

  • Collect the costs of each activity. These are known as cost pools and are directly equivalent to traditional cost centres.

  • Charge support overheads to products on the basis of their usage

ABC and Traditional Costing

In Traditional Costing System, overhead costs are assumed to be influenced only by units produced and in this system, batch level, product level and facility level activities are fixed a cost which do not vary as production volume changes. In ABC, variable overhead is appropriately traced to individual products.

The costs incurred in the units produced have been traditionally treated as variable overheads. But when fixed overheads are apportioned on the basis of units made, as in traditional costing, such apportionment is likely to be arbitrary and also may not reflect activities and cost actually consumed by the products.

ABC improves the product costing procedure as compared to traditional costing. Under ABC, two level activities batch level and product level are assumed to influence fixed overhead costs and batch level and product level thus are accepted as non unit based cost drivers.

By establishing the link between these cost drives and fixed overhead costs, they are finally traced to individual products.

The difference between ABC and traditional costing system may be summarized an follows:

  • Both the costing systems follow a two stage allocation procedure.

  • In ABC in the first stage overhead costs are assigned to each major activity and not to departments and many activity-based costs pools or cost centres are created whereas in traditional costing, overheads are collected department-wise.

  • In traditional costing, overhead cost of service department are allocated to production departments and therefor in this costing system finally only fewer cost pools exist but ABC creates separate cost pools for service activities are assigned directly to specific products through applying cost driver rates.

    Thus in ABC there is no need to allocate/reapportion overheads of service departments.

Advantages of Activity Based Costing

  1. It helps understanding the behavior of overhead costs and their relationship to products, services, customers and market segment.

  2. It provides the right information for performance measurement because it focuses on activities rather than resources.

  3. It provides accurate information on profit margin and performance measurement for profit improvement.

  4. It helps to allocate the resources to those activities that will increase shareholders value.

  5. It gives businesses an opportunity to improve their competitive position through better information it links profitability analysis to operational decisions.

  6. It ensures that the cost of non-value added activities is visible to management.

  7. The understanding of the cost driver for each activity gives better control over the factors, which cause costs.

Disadvantage of Activity Based Costing

  1. It is essentially not the panacea for all ills.

  2. It can be difficult to find out what costs apply in a particular activity.

  3. Some areas of activity overlap and are difficult to separate.

  4. ABC is a costly exercise that it absorbs a lot of resources.

  5. Too much emphasis on customer viability can lead to problems such as cheaper products and, therefore, potentially lower sales.

  6. It may lead to weaker customer segmentation.

  7. It takes no account of opportunity cost.

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