Activity Based Costing (ABC) is a costing method in accounting that focuses on different activities and resources that are essential to produce a product or service. The main focus of this costing method is to identify and analyze the activities and cost drivers that contribute to the production and then to assign costs to those activities based on their usage.
In more technical terms, Activity Based Costing methods is a method of assigning overhead and indirect costs to products and services. Traditional methods of costing assume that all the products consume overhead resources in the same way i.e. all the overhead costs are assigned on average.
In real case scenarios, overhead costs or indirect costs are incurred differently by different products based on their nature. Some parts or products may require more set up time, other parts or products may require more time in testing. Simply generalizing the overhead and indirect costs may not reflect the accurate cost. Hence, ABC simplifies the overhead and indirect costs to products or services.
Activity Based Costing was popularized by Robert S. Kaplan and Robin Cooper in their book, “Cost and Effect: Using Integrated Cost Systems to Drive Profitability and Performance”
Basic Principles of Activity Based Accounting (ABC) Methods
Activities Consume Resources
ABC method states that the resources consumed in the production of a product or service are determined by the activities involved or required to produce the product or service. Through this recognition, ABC methods aim to effectively and accurately allocate costs i.e. assigning the costs of resources to the specific activities that consume them.
For instance, production of a car consumes the amount of labor, material and equipment.
Different Products and Services consume resources differently
This principle suggests that different products or services require or consume resources in different ways. The labor, material and equipment for the production of a car is different from labor material and equipment for the production of a motorbike hence the cost assignment is different.
Costs are assigned based on activities and cost drivers
In traditional costing, costs are assigned based on arbitrary assumptions or in averages. This may not accurately reflect the actual cost of the product or services. ABC method first identifies the activities related then assign the resources for the activities and then cost is calculated based on the resources allotted. This provides the actual consumption of resources.
Accurate cost information is essential for decision making
ABC methods overcome the weakness of the traditional costing methods. Identifying the activities involved in the production, allotting the resources for those activities eventually lead to accurate cost determination. The quality of information or due diligence of the process is essential for informed decision making.
Traditional costing methods used assumptions hence, the reliability of such costing methods was less. In the ABC method, cost information is accurately represented, which increases the credibility of decisions made.
ABC method is ongoing process
ABC involves ongoing refinement of process and system. In the ABC method, identification of activities and new cost drivers never stops. New technology, reengineering the process and redesigning of systems etc. lead to changes in activities and resources. Eventually this will help to improve efficiency and articulate the accurate and effective costing of products and services.
Along with this, the environment around the products and services is dynamic and keeps changing. To match with the changing environment, it is necessary for the ABC method to improve continuously.
Advantages of Activity Based Costing Method
Activity Based Costing (ABC) is a cost accounting method. This method provides a more accurate understanding of the costs of products and services by identifying the specific activities that drive indirect costs. Here are some of the key advantages of ABC:
Accurate Product Costing
The ABC method of cost accounting provides an accurate picture of the true cost of each product or service. This costing method assigns resources to the activities and assigns costs based on actual resource consumption. This means that products that consume more resources, such as setup time or testing time, will be assigned a higher share of indirect costs. Such true reflection of activities, resources and consumption help companies to make better informed decisions.
Costing is important for determining price, product mix and resource allocation. Accurate product costing provides competitive advantage in the business environment.
Improved Decision Making
Costing holds a strategic implication in any business. Accurate costing helps any company to further design their business strategy. With detailed and accurate cost information, ABC can assist decision making at different levels of the organization. Accurate costing is essential during budgeting, resource allocation, pricing strategies, product mix strategies, marketing strategies etc.
Better Resource Allocation
ABC identifies the activities involved during the production and associates the cost drivers related. This significantly helps companies to identify the areas where extra resources are necessary and where the company can reduce the costs by eliminating or optimizing activities that are not adding value to the production process.
ABC helps companies focus on activities that are truly essential to the production process. Companies can improve efficiency and reduce costs. This can help companies allocate resources more effectively and efficiently.
Enhanced Product and service Design
ABC is a continuous process. New technology, process reengineering, system redesign is integral part of any company and ABC method considers all these factors. The ABC method regularly considers the activities that drive costs in the production process. This helps companies design products and services that are more cost-effective to produce. By focusing on activities that are adding value to the production process, companies can reduce costs while maintaining or improving the quality of their products and services.
ABC can help companies improve their profitability by giving them a more accurate understanding of the costs of their products and services. Companies can increase efficiency and reduce costs if they focus on the activities that add value to the production process.
Better alignment of costs and activities
A more transparent view of the cost structure of the company can be found by ABC aligning costs with the activities that drive them. ABC identifies the activities that a company performs, and assigns costs to each activity based on its use of resources.
Disadvantages of Activity Based Costing Method
The ABC method has some disadvantages. So of such disadvantages are:
Cost and Time
The ABC method follows a due process for calculation of costs. ALso, it requires more detailed analysis of a company’s activities and the resources used to perform them. Along with the time factor, ABC costing methods require investment in process, human resources etc. Also, companies and businesses have to collect data on activities and cost drivers, set up cost pools, assign and allocate costs to activities etc. All such procedures, procedures and inputs require time and incur costs.
The ABC method of costing follows a detailed and complex approach. ABC needs to recognize multiple cost drivers. These cost drivers are the factors that incurs the cost. Such factors include number of setups, orders, direct and indirect labors, complexity of the products etc.
ALong with this, this method of costing also makes a detailed comprehension of all the activities or processes that take place in the organization, both value added and nonvalue added activities.. Along with it, the method needs documentation of cost and resources incurred by those activities.
All such requirements make the ABC method a complex approach.
Difficult to choose appropriate cost drivers
Selection of cost drivers is a difficult task. There are multiple factors that influence the cost driver factor hence influence the ABC methods of costing. An ideal cost driver must have a clear cause and effect relationship with the consumption of resources. It is difficult to establish this relationship.
The selection of cost drivers depends on subjective judgment. There are different opinions and interpretations for selecting the activities and processes to the consumptions of resources or costs. Different stakeholders have different approaches to activities and stakeholders, selecting the best that benefits the organizations. Hence it is difficult to select the cost drivers.
Similarly, availability of data , accuracy of data, the processes and complexities in operation and time and cost constraints also influence organization in selecting the cost drivers. This reason makes the ABC method not an easy approach.
The ABC method may not be applicable for all businesses or organizations. For many organizations and businesses, the ABC method may remain irrelevant as they may not have complex operations or they may lack resources for comprehending cost drivers etc.
Similarly, businesses with small operation or capacity or structure may not prefer the ABC method of costing for their operations. Only businesses with large operations and resources to maintain the ABC method of costing go for this method. Hence, the limited applicability of this method stands as a disadvantage.
Data Accuracy and Availability
Activity Based Costing methods require inputs for better calculation and projections of cost. The better the inputs the accurate and relevant the costing result. For businesses, it is difficult to obtain relevant and accurate data to allocate the cost. It is difficult to get the data for cost drivers and from data sources.
It is even more challenging to validate the obtained data and ensure the completeness of the data. The nature of activities, availability of data, ease of extraction of data impact the credibility of this method. Due to such difficulties in data management, the credibility of ABC Costing is questioned.