Question

Describe the Activity-Based Costing method in the context of:

Characteristics, features and challenges and Application within service industries.

Answer 1

ABC is an alternative approach to the traditional method of absorption costing. We
have observed that traditional absorption costing, calculates the total cost as
direct cost and share of production overheads, absorbed either on the basis of
units, labour hours/machine hours or some other reasonable basis. Using such
bases for absorption may at times have undesirable effects on decision making,
especially when there is no relationship between the cost be absorbed and the
basis of absorption.
For e.g. if a company produces two products namely Twitter & Glitter. Twitter takes 2 hours
to manufacture while Glitter takes only 0.5hrs. If the company adopts absorption costing,
Twitter would get a larger share of the overheads, based on hours as a base for absorption.
However it is later realized that for the purpose of production ,material issues are made
from the stores on a monthly basis for Twitter while the issues are required to be made
daily for Glitter. Hence it is apparent that the cost of operating the materials issue process is
driven primarily by Glitter and not Twitter and hence larger share of the costs should go to
Glitter. To overcome this inherent flow in traditional absorption costing, ABC was developed
as an alternative.
Rather than treating overheads as one huge block of cost that is charged out per product or
per hour, activity based costing attempts to bifurcate overheads into several activities (for
e.g. Quality control,setups,materials issue,etc). It then goes onto identify what actually
drives these activity costs (cost driver).In the above e.g. Material issues are driven by no. of
materials issues made. So greater the material issues to Glitter, greater is the share of
overhead cost charged to Glitter. Hence ABC is comparatively a fairer to absorbing
overheads as compared to traditional absorption costing methods!

There are a number of steps that organizations have to go through to establish an
activity-based costing system
1. Identify key activities that consume resources and incur overheads within
an organization.
2. Determine what drives activity costs(cost driver)
3. Group together costs that relate to each activity-this group is a cost pool.
4. Calculate cost driver rate
= Activity cost / no. of cost drivers
5. Based on actual number of cost drivers, charge costs to products/ services.

challenges:

The process of identifying activities and drivers is a tedious exercise and very time
consuming.
2. ABC is expensive for business in practice.
3. Selection of activities and activity rates may be arbitrary.
4. Not suitable in industries where most costs are driven by volume of production.
5. There is little real life evidence to demonstrate that ABC improves corporate
decision-making and/or profitability.

application:

The use of ABC as against traditional (Absorption costing) systems will have significant
impact on the organization.
 It helps determine accurate costs and profitability accurately and hence can
change the Sales mix and strategy of an organization
 ABC may help the company to identify profitable and non-profitable
products/services.
 ABC can play an important role in determining the prices of
products/services offered by the organization.