Advantages of Activity Based Costing (ABC):
The following are the advantages of ABC:
1. Accurate Product Cost:
ABC brings accuracy and reliability in product cost determination by focusing on cause and effect relationship in the cost incurrence. It recognises that it is activities which cause costs, not products and it is product which consume activities. In advanced manufacturing environment and technology where support functions overheads constitute a large share of total costs, ABC provides more realistic product costs.
ABC produces reliable and correct product cost data in case of greater diversity among the products manufactured such as low-volume products, high-volume products. Traditional costing system is likely to bring errors and approximation in product cost determination due to using arbitrary apportionment and absorption methods.
2. Information about Cost Behaviour:
ABC identifies the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product. With ABC, managers are able to control many fixed overhead costs by exercising more control over the activities which have caused these fixed overhead costs. This is possible since behaviour of many fixed overhead costs in relation to activities now become more visible and clear.
3. Tracing of Activities for the Cost Object:
ABC uses multiple cost drivers, many of which are transaction based rather than product volume. Further, ABC is concerned with all activities within and beyond the factory to trace more overheads to the products.
4. Tracing of Overhead Costs:
ABC traces costs to areas of managerial responsibility, processes, customers, departments besides the product costs.
5. Better Decision Making:
ABC improves greatly the manager’s decision making as they can use more reliable product cost data. ABC helps usefully in fixing selling prices of products as more correct data of product cost is now readily available.
6. Cost Management:
ABC provides cost driver rates and information on transaction volumes which are very useful to management for cost management and performance appraisal of responsibility centres. Cost driver rates can be used advantageously for the design of new products or existing products as they indicate overhead costs that are likely to be applied in costing the product.
7. Use of Excess Capacity and Cost Reduction:
ABC, through the processes of pooling of activity costs and the identification of cost drivers, can lead to a range of applications. These include the identification of spare capacity and the fostering of cost reduction by comparing the resources required under ABC with the resources that are currently provided. This provides a platform for the development of activity-based budgeting in which the resource relationships identified by ABC are used to project future resource requirements.
8. Benefit to Service Industry:
Service organizations, such as banks, hospitals and government departments, have very different characteristics than manufacturing firms. Service organizations have almost no direct costs, most of the costs are overheads and they do not hold stocks of service as the service is consumed when it is produced. Traditional costing has generally been considered inappropriate for these organizations, whereas ABC offers the potential of benefits from improved decision making and cost management.
An ABC system can provide better costing information and help management manage efficiently and gain a better under-standing of the firm’s competitive advantages, strengths and weaknesses. Often, managers recognize needs for a better costing system such as ABC when they are experiencing increased lost sales due to erroneous pricing that resulted from inaccurate costing data.
An ABC system has the most impact on firms that have areas with large, increasing expenses or have numerous products, services, customers, processes, or a combination of these. Example are plants that produce standard and custom products, high-volume and low-volume products, or mature and new products.
Firms that accept small and large orders, offer standard and customized deliveries, or satisfy all customers including those who demand frequent changes and services either before or after the delivery, and customers who hardly ever request special services can benefit substantially from activity-based costing systems.
Colin Drury observes:
“ABC provides not only a base for calculating more accurate product costs but also a mechanism for managing costs. An ABC system focuses management attention on the underlying causes of costs. It assumes that resource-consuming activities cause costs and that products incur costs through the activities they require for designing, engineering, manufacturing, marketing, delivery, invoicing and servicing. By collecting and reporting on the significant activities in which a business engages, it is possible to understand and manage costs more effectively.
With an ABC system, costs are managed in the long run by controlling the activities that drive them. In other words, the aim is to manage the activities rather than costs. By managing the forces that cause the activities (i.e., cost drivers), costs will be managed in the long-term. The application of activity-based systems may have the greatest potential for contributing to cost management, budgeting, and control and performance evaluation.”
According to Weil and Maher:
“Activity-based costing plays an important role in companies’ strategies and long-range plans to develop a competitive cost advantage. While activity-based costing focuses attention on activities in allocating overhead costs to products, activity-based management focuses on managing activities to reduce costs. Cost reduction generally requires a change in activities. Top management can send notices to company employees to reduce costs, but the implementation requires a change in activities. If you have lived in a city that has had to reduce costs, you know that achieving the reduction required a change in activities such as fewer police patrols, a cut in library hours, and reduced social services. An entity cannot know the effect of a change in activities on costs without the type of cost information provided by activity-based costing.”
Demerits of Activity Based Costing (ABC):
The following are the demerits of ABC:
1. Expensive and Complex:
ABC has numerous cost pools and multiple cost drivers and therefore can-be more complex than traditional product costing systems. It can prove costly to manage ABC system.
2. Selection of Drivers:
Some difficulties emerge in the implementation of ABC system, such as selection of cost drivers, assignment of common costs, varying cost driver rates etc.
3. Disadvantages to Smaller Firms:
ABC has different levels of utility for different organisation such as large manufacturing firm can use it more usefully than the smaller firms. Also, it is likely that firms depending on cost-plus pricing can take advantages from ABC as it gives accurate product cost. But those firms who use market based prices may not favour ABC. The level of technology and manufacturing environment prevailing in different firms also affect the application of ABC.
4. Measurement Difficulties:
The main costs and limitations of an ABC system are the measurements necessary to implement it. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers to serve as cost allocation bases. Even basic ABC systems require many calculations to determine costs of products and services. These measurements are costly. Activity cost rates also need to be updated regularly.