Question

Do a little research on Mr Google, and see when ABC starts becoming a costing method

Answer 1

Activity-based costing (ABC) is a method of assigning costs to products or services based on the resources that they consume. Its aim, The Economist once wrote, is “to change the way in which costs are counted” .

ABC is an alternative to traditional accounting in which a business's overheads (indirect costs such as lighting, heating and marketing) are allocated in proportion to an activity's direct costs. This is unsatisfactory because two activities that absorb the same direct costs can use very different amounts of overhead. A mass-produced industrial robot, for instance, can use the same amount of labour and materials as a customised robot. But the customised robot uses far more of the company engineers' time (an overhead) than does the mass-produced one.

This difference would not be reflected in traditional costing systems. Hence a company that makes more and more customised products (and bases its pricing on historic costings) can soon find itself making large losses. As new technologies make it easier for firms to customise products, the importance of allocating indirect costs accurately increases.

Introducing activity-based costing is not a simple task—it is by no means as easy as ABC. For a start, all business activities must be broken down into their discrete components. As part of its ABC programme, for example, ABB, a Swiss-Swedish power company, divided its purchasing activity into things like negotiating with suppliers, updating the database, issuing purchase orders and handling com-plaints.

Large firms should try a pilot scheme before implementing the system throughout their organisation. The information essential for ABC may not be readily available and may have to be calculated specially for the purpose. This involves making many new measurements. Larger companies often hire consultants who are specialists in the area to help them get a system up and running.

Activity-based costing became popular in the early 1980s largely because of growing dissatisfaction with traditional ways of allocating costs. After a strong start, however, it fell into a period of disrepute. Even Robert Kaplan (see article), a Harvard Business School professor sometimes credited with being its founding father, has admitted that it stagnated in the 1990s. The difficulty lay in translating the theory into action. Many companies were not prepared to give up their traditional cost-control mechanisms in favour of ABC.

Activity-based costing enhances the costing process in three ways. First, it expands the number of cost pools that can be used to assemble overhead costs. Instead of accumulating all costs in one companywide pool, it pools costs by activity. It also creates new bases for assigning overhead costs to items such that costs are allocated on the basis of the activities that generate costs instead of on volume measures such as machine hours or direct labor costs. Finally, ABC system alters the nature of several indirect costs, making costs previously considered indirect such as depreciation, inspection or power are traced to certain activities.

However, ABC transfers overhead costs from high-volume products to low-volume products, raising the unit cost of low-volume products.

Uses of Activity Based Costing

The fundamental advantage of using an ABC system is to more precisely determine how overhead is used. Once you have an ABC system, you can obtain better information about the following issues:

• Activity costs. ABC is designed to track the cost of activities, so you can use it to see if activity costs are in line with industry standards. If not, ABC is an excellent feedback tool for measuring the ongoing cost of specific services as management focuses on cost reduction.
• Make or buy. ABC provides a comprehensive view of every cost associated with the in-house manufacture of a product, so that you can see precisely which costs will be eliminated if an item is outsourced, versus which costs will remain.
• Distribution cost. The typical company uses a variety of distribution channels to sell its products, such as retail, Internet, distributors, and mail order catalogs. Most of the structural cost of maintaining a distribution channel is overhead, so if you can make a reasonable determination of which distribution channels are using overhead, you can make decisions to alter how distribution channels are used, or even to drop unprofitable channels.
• Production facility cost. It is usually quite easy to segregate overhead costs at the plant-wide level, so you can compare the costs of production between different facilities.