Question

Within the Discussion Board area, write 500 words that respond to the following questions with your thoughts, ideas, and comments. This will be the foundation for future discussions by your classmates. Be substantive and clear, and use examples to reinforce your ideas. Discuss the 2 pros and 2 cons of activity-based costing. Give an example of a situation where activity-based costing could be used effectively. Explain your reason.

Answer 1

PROS OF ACTIVITY BASED COSTING

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.

2. 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.

3. 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.

CONS OF ACTIVITY BASED COSTING

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.

situation where activity-based costing could be used effectively

Activity-based costing is an approach that allocates fixed overhead and administrative costs to activities, which are cost-incurring events. Activity-based costing assigns costs to those factors and activities that have a direct cause and effect relationship with a particular overhead cost. The approach then allocates the activity costs to those products or services that actually require the activities.

Manufacturing

Activity-based costing originated in manufacturing as a better method of allocating overhead costs than the traditional method of using direct labor. With the move from labor-intensive to automation and more capital-intensive facilities and processes, manufacturing firms needed a method that better suited the new operating environment. Manufacturers use activity-based costing when overhead costs make up a significant percentage of overall expenses. Manufacturers also use it when they produce product lines of varying quantity and complexity or produce a broad array of products requiring various service support levels.

Construction

In large commercial and industrial construction, many companies exhibit characteristics that warrant the use of activity-based costing. They have significant overhead, such as construction bond purchases, large equipment and machinery and skilled personnel. They also usually either have a range of complex service lines – for example, two warehouse construction projects and two office exterior renovations of different sizes – or a diverse range of projects. Through the use of activity-based costing, project estimators and supervisors can assign costs to the correct items and projects, better enabling the construction firm to be cost-competitive by project.

Health Care

For many years health care providers could simply raise their prices or offer more services to cover increasing costs. However, in recent years, Medicare, health maintenance organizations and managed care entities have capped reimbursement rates. To more closely allocate a hospital’s fixed overhead costs to those services that actually utilize a higher portion of the hospital’s resources, more hospitals began using activity-based costing. The dynamics of a surgical and trauma hospital – a wide range or varied, yet complex quantity -- fit the parameters for activity-based costing use