Limitations of Activity-Based Costing ABC

Under Conventional or Traditional Costing System, overhead expenses are identified initially with the cost centres which comprise of both the production departments and service departments. The costs of service departments are then distributed, on some equitable bases, to the production departments. These (production) departmental overhead expenses are finally assigned, or charged, to products on a suitable basis. The factors which influence the cost of a particular activity should identified, which are known as Cost Drivers. ABC is based on the assumption that cost behavior is influenced by cost drivers. It should be noted that directs costs do not need cost drivers as they can be identified directly to a product.

  1. It facilitates the preparation of an activity-based budget by providing the management with a clear view on the details of various activities.
  2. As the cost statement lists all the activities that make up the cost of a product, it forces the organization to look into its non-value-adding activities, which the management can eliminate.
  3. However, the circuit board for the aeroplane is tested for a longer time by highly paid technicians because it must be 100% error-free.
  4. How can businesses get a handle on all these costs and turn indirect costs into direct costs?
  5. Complete these steps for each one of your products or services, and compare them!
  6. (b) It would be difficult to correlate the marginal increase in cost with a particular cost driver.

This is the same cost figure used for the plantwide and department allocation methods we discussed earlier. Activity-based costing simply provides a more refined way to allocate the same overhead costs to products. Under the absorption costing method, the company will assign an additional $2 to each widget for fixed overhead costs ($20,000 total / 10,000 widgets produced in the month).

Costs allocated to each activity represent the resources consumed by it. ABC is based on the principle that ‘prod­ucts consume activities.’ Traditional cost systems allocate costs based on direct labour, material costs, revenue or other simplistic methods. As a result, traditional systems tend to over-cost high volume products, services, and customers; and under-cost low volume.

Activity-Based Costing Method in Accounting

Activity-based costing may also generate value in areas that are not immediately apparent. For example, a more detailed approach to costing for areas of indirect or semi-direct costs can provide valuable insights into the true cost of patient encounters. At the same time, this helps mitigate the distortion of results that can occur when these costs are allocated solely based on statistics such as revenues, expenses, or FTEs. To better understand how to match effort with impact, consider a hip replacement surgery. Time-driven activity-based costing can be used for high-cost, time-driven activities such as surgical suite utilization, while activity-based costing should be used for high-cost implants, medical supplies, and pharmaceuticals. The assignment of actual vendor cost to the chargeable item, or even directly to the individual patient encounter, can provide valuable insight into the impact of physician preferences on the cost of an episode of care.

As some products are produced in large batches and some in small batches.  Implementing an ABC system is a major project that requires substantial
resources. Data
concerning numerous cost drivers must be collected, checked, and entered into
the system.

Activity-based costing/management and its implications for operations management

Activity based budgeting is especially useful in case of budgeting of indirect costs. The activity based costing method is helpful in ascertaining areas where cost reductions are possible. It charges overhead costs to different jobs or products in proportion to the cost driving activities in place of a blanket rate based on direct labour cost or direct hours or machine hours. ABC does not confined itself to the allocation to indirect costs to departments as it is done in the conventional costing but it identifies individual activity as the lowest unit for indirect cost allocation.

The total amount of overhead should be the same whether using activity-based costing or traditional methods of cost allocation to products. The primary difference between activity-based costing and the traditional allocation methods is the amount of detail; particularly, the number of activities used to assign overhead costs to products. In practice, companies using activity-based costing generally use more than four activities because more than four activities are important. Activity-based costing or ABC costing method uses cost pools and drivers to calculate cost driver rates. As the name suggests, it is the accounting of costs based on the activities.

Activity Based Costing – Requirements of ABC System

It may be noted here that the prime costs are identified with, and charged directly to, the products. Activity Based Management (ABM) differs from Activity Based Costing (ABC). Activity Based Costing (ABC) establishes relationship between overheads costs and activities in order to ensure that the overheads costs are more precisely allocated to products, services or customers segments. While Activity Based Management (ABM) focuses on managing activities, reducing costs and improving customer value. Activity cost centres are, sometimes, similar to cost centres used under traditional costing system.

Managers can set cost reduction targets in terms of reducing the cost per unit in relation to cost allocation base in different activities areas. For instance, a manager may aim at reducing cost of transporting the product from Rs. 5 per unit to Rs. 4.50 per unit. (iii) Having identified activities and their costs, next step is to determine the basis (cost driver) for allocating activity-wise costs.

Your friend has more complicated ordering, storage, product testing (one of the more desirable jobs, nevertheless), and packing in containers. Presumably, you can set the machinery to one setting to obtain the desired product quality and taste. Your friend has to set the limitations of activity based costing machines each time a new flavor is produced. Although both of you produce the same total volume of ice cream, it is not hard to imagine that your friend’s overhead costs would be considerably higher. The causes for incurrence of overhead costs are known as cost drivers.

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Nevertheless, since there are usually more activities than cost centers and often cost driver rates are more justifiable than the rates used by absorption costing, an ABC system, most of the times, produces more accurate results. There is a very high probability of an ABC system providing a different picture of product costs than what is provided by the traditional system. However, since both methods make assumptions about the behaviour and cause of costs, it cannot be said with certainty that ABC shall always produce more precise results than traditional costing. Cost of activity will be charged to the product using cost driver rate according to the requirement of activities of each product. For instance, a product may require 10 machine setups and 1 inspection related activity. Thus, product will be charged for both machine related set up activity cost and inspection activity cost.

With a better breakup of costs, it is easy to reanalyze the production process to search for improved areas. Applying this method to the product helps the organization identify the product ranges that are commercially viable apart from those which are draining resources and adding up the cost. For example, the number of workers would be the cost driver for the total salary paid to the factory workers. More workers would drive the cost pool up, and fewer workers would bring down the cost. In this section, these studies will be reviewed to better understand the diffusion process for ABC and to provide some explanations for the ABC paradox (Gosselin, 1997; Kennedy & Affleck-Graves, 2001).

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