Question

Q4. Define Activity Based Costing. Why we need Activity Based Costing? What are the advantages and limitations of Activity Based Costing?

Answer 1

Definition Activity Based Costing

Activity Based Costing is an accounting methodology that assigns costs to activities rather than products or services. This enables resources & overhead costs to be more accurately assigned to products or services that consume them.

Need of Activity Based Costing

The Need of Activity Based Costing are as given below.

1- Activity Based Costing system can effectively support the management by furnishing data, at the operational level and strategic level. Accurate product costing will help the management to compare the profits of various customers, product lines and to decide on price strategy etc.

2- Information generated by Activity Based Costing system can also encourage management to redesign the products.

3- Activity Based Costing System can change the method of evaluation of new process technologies, to reduce setup times, rationalization of plan layout inorder to reduce or lower material handling cost, improve quality etc.

4- Activity Based Costing system will report on the resource spending.

5- Activity Based Costing analysis helps managers focus their attention and energy on improving activities and the actions allow the insights from Activity Based Costing to be translated into increased profits.

6- Performance base accurate feedback can be provided to cost centre managers.

7- Accurate information on product costs anables better decisions to be made on pricing, marketing, product design and product mix.

Advantages of Activity Based Costing

The main advantages of using Activity Based Costing are as given belows.

1. More accurate costing of products or services.

2. Better understanding overhead.

3. Utilizes unit cost rather than just total cost.

4. Integrates well with six sigma and other continuous improvement programs.

5. Makes visible waste and non-value added.

6. Supports performance management and scorecards.

7. Enables costing of processes, supply chains and value streams.

8. Activity Based Costing mirrors way work is done.

9. Facilitates benchmarking.

Limitations of Activity Based Costing

The limitations of Activity Based Costing system are as follows:

1- Activity Based Costing System is very costly to implement and maintain.

2- Activity Based Costing system produces the reports that are different from the profit and loss reports produced through traditional costing systems.

3- As most of the companies are using traditional costing systems, so because of the difference in the costing basis the costing and financial reports of the two companies of the same industry could not be compared.

4- Adaptability of Activity Based Costing System is not suitable for all kind of companies because small companies have not many resources to adapt it and have too many activities but size of transactions is too low.

5- Data Produced through Activity Based Costing System can easily misinterpret and can lead towards wrong decisions.

6- Activity Based Costing system costs are allocated on the base of cost drivers and activities undertaken to manufacture the product, definitely, it provides the accurate and proper allocation of the costs to the products but there is a danger of over or under costing of the products when irrelevant cost drivers or activities are assigned to the products.