Question

activity based costing

Answer 1

We'll go step but step to tell you about Activity Based Costing.

1. What is Activity Based Costing

Activity Based Costing (ABC for short) is a method of Costing where the different activities that exist in an organization are identified and the cost of each activity is assigned to ask the products and/or services the organization has, based on their usage of the activity.

This model assigns more overhead (indirect costs) to the direct costs compared to the conventional choosing model.

2. Goals of Activity Based Costing

​​​​​​After getting a fair idea of what activity based Costing is, let's move on to the question of "Why Activity Based Costing ?".

1. Using ABC, an organization will be able to understand the costs and cost elements of products, activities and services.
2. Identifying the costs as such would help the company in deciding whether to discontinue products and services that are unprofitable, and to lower the prices of products that are overpriced. This is called the product and portfolio aim. Alternatively, the company can choose to go on a path of 'Process Re-engineering' whereby ineffective and inefficient processes are discontinued and replaced with processes that have a higher yeild.
3. It is used as a tool for assessing the product and customer costs based on the production and performing processes.

3. Drawbacks of Activity Based Costing

Manually driven activity based Costing is inefficient, costly and a waste of resources, as the results are not proportionate to the resources, time and money spent. It can also be argued that there are alternate methods that provide more value.

Another drawback is that products may end up subsidising other products within the organization because of the fact that all products are not responsible for indirect costs equally . Let us understand this with an example. Imagine two products X and Y, both of which uses the same amount of Direct Labor and Direct Materials, and both have to go through a heat treatment process that uses a very expensive machine.

Let us say 'X' takes 2 hours in the machine and 'Y' takes only half an hour, but since the direct labour and Direct Materials are the same, the cost would be apportioned in a broad 'On Cost percentage'.

This means that eventhough 'Y' used only one fourth of the time it would get the same cost allocation. Thereby making 'Y' costlier, and on the flipside, 'X' is cheaper to produce because of the model of costing used.

This led to a lot of managers making inaccurate decisions, because the data they got from the model of costing was inaccurate, especially where there were multiple products.

4. Benefits of Activity Based Costing

Peter F Drucker wrote that "Traditional cost accounting focuses on what it costs to do something, activity based Costing also records the cost of not doing something."

Activity Based Costing records the costs that Traditional cost accounting cannot.

For example, traditional cost accounting records the cost of making a computer chip, activity based Costing would also consider the cost incurred in waiting for an essential part.