18 January 2015
One of the best tools for refining a costing system is activity-based costing. Activity based costing (ABC) systems refine costing systems by focusing on individual activities as the fundamental cost objects. An activity is an event, task, or unit of work with a specified purpose; for example, designing products, setting up machines, operating machines, and distributing products, setting up machines, operating and distributing products. ABC systems calculate the costs of individual activities and assign costs to cost objects such as products and services on the basis of the activities undertaken to produce each product or service
ABC is more expensive than the traditional system. So a cost-benefit analysis is desirable. The benefits of ABC are many.
1. In the traditional system cost analysis is done by product. In ABC managers focus attention on activities rather than products because activities in various departments may be combined and costs of similar activities ascertained e.g. quality control, handling of materials, repairs to machines, etc. If detailed costs are kept by activities, the total company costs for each activity can be obtained, analysed, planned and controlled.
2. Because costs are identified with activities and then allocated to products or services, based on appropriate cost drivers, more accurate product/service costs result. Since overhead or indirect costs occupies a significant proportion of the total costs of the firm, the overall impact of allocation of indirect costs to products/ services more accurately is significant.
3. Managers manage activities and not products. Change in activities lead to changes in costs. Therefore, if the activities are managed well, costs will fall and resulting products will be more competitive.
4. Allocating overhead cost to production based on a single cost driver (allocation base) can result in an unrealistic product cost because the traditional system fails to capture cause and effect relationships. To manage activities better and to make wiser economic decisions, managers need to identify the relationships of causes (activities) and effects (costs) in a more detailed and accurate manner. ABC focuses on this aspect. It may be mentioned that activities drive costs. Therefore, costs should be assigned to factors that cause them.
5. ABC highlights problem areas that deserve management’s attention and more detailed analysis. Many actions are possible on pricing, on process technology, on product design, on operational movements and on product mix, once management realises that a large number of its products and customers may be breakeven or unprofitable. The ABC systems are useful in setting priorities for managerial attention and action.
ABC is not free from certain weakness, as argued by the critics. They are mentioned below:
1. ABC fails to encourage managers to think about changing work processes to make business more competitive.
2. ABC does not conform to generally accepted accounting principles in some areas. For example, ABC encourages allocation of such non-product costs as research and development to products while committed product costs such as factory depreciation and not allocated to products. In the USA, most companies have accordingly used ABC for internal analysis and continued using the traditional costing for external reporting.
3. Using ABC for short-run decisions may sometimes prove costly in the long run. Consider, for example, the decision about lowering sales order handling costs by eliminating small orders that generate lower margins. While this strategy reduces the number of sales orders (the driver), customers may want frequent delivery at small lots at infrequent intervals. In a competitive environment (when other companies may be willing to meet the customers’ needs); long term profits may suffer due to elimination of small orders.
4. ABC does not encourage the identification and removal of constraints creating delays and excesses. An overemphasis on cost reduction without regard to the constraints does not create an environment for learning about the problems and their management.
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