Question

how ABC(activity based costing) method overcomes the problem of over/under allocation of overheads between products.

Answer 1

In traditional costing, the manufacturing overhead is allocated on the basis of one common allocation base
which can be either machine hours, labour hours, direct labour dollars etc whereas ABC costing is a technique in which an organisation identifies activity and assign the cost of each activity with resources to all products and services according to the actual consumption by each due to which correct amount of cost is allocated to each product and thus there is no over/under allocation of overheads between products. Let us study the below concepts for more clarification :- 1.These both are the methods to allocate indirect costs to products. But the thing is that, ABC costing is more accurate in compared to Traditional product costs as it assigns the indirect cost to a product in accordance to their consumption of that specific service whereas Traditional costing blindly assigns the cost to all products based on an average rate. On the other hand, ABC costing is liitle complex and time consuming in compared to Traditional Costing as it involves careful allocation of costs. ABC costing is also more thorough than Traditional product cost methods as it considers Non-manufacturing expenses like Administration costs which Traditional Costing doesn't. 2.In ABC costing system, costs are allocated on the basis of cost drivers by wich it provides the accurate and proper allocation of the costs to the products but there are chances when irrelevant cost drivers or activities are assigned to the products due to which there can be over or under costing of the products. The over or under costing of the products is referred to as product cost cross subsidization. Overcosting of a product may result in a higher Selling Price due to which sales volume will be affected and under costing of a product may result in a lower sales price which will in turn increase the sales volume but will not generate adequate profit.    3. ABC can be used to improve profitability as there is more accuracy in it. It provides a comprehensive understanding of overheads and causes of their occurence. It drives the attention of management towards costly and non value adding activites so that they can focus on that and eliminate them. It helps in continuous improvement and better performance by identifying inefficient product, department or activities, allocating resouces on more profitable products and fixing the price of a product. 4.Limitations of ABC:- First of all, it is difficult and time consuming as information has to be collected about the costs and their cost drivers. Secondly it is costly to implement, run and manage an ABC system.Small businesses cannot afford it. Thirdly, some of the costs remain unassigned through this method and therefore have to be allocated on a random basis. Fourthly, there can be a variation in the reports genearted through traditional costing.