Question

Why do activity-based cost drivers provide a more accurate allocation of overhead in an automated manufacturing environment?

Answer 1

Traditionally, costing systems always used volume-related measures, such as direct labour hours or machine hours to allocate overheads to products. Earlier costs were first collected for production departments and service departments and finally, the costs of production departments and the costs of production departments were absorbed by jobs for processes. Now in the context of activity-based costing the costs are collected according to activities such as material ordering, material handling, quality testing, machine set-ups, customer support service, etc. and jobs and processes for which cost collection is being attempted are loaded with costs of these activities rationally. Traditional product cost systems, which assume that products consume all resources in proportion to their production volumes, thus, report distorted product costs. Traditional costing systems were designed decades ago when most companies manufactured a narrow range of products and direct labour and direct material were dominant factory costs. Overhead costs were small and thus, the inappropriate overhead allocation was insignificant. Since the information processing costs were higher it was difficult to justify more sophisticated overhead allocation method. In the present era, companies produce a wide range of products and direct costs represent only a small percentage of total costs. The intense global competition has made decisions errors due to poor cost information more probable and more costly. These changes contributed to the advent of ‘activity-based costing’.

Reasons for introduction of ABC

1. Traditional costing fails to capture cause and effect relationship.
2. Additional costing often fails to highlight inter-relationship among activities in different departments.
3. Growing dissatisfaction among the working executives regarding traditional costing which is based on average and estimation.
4. Traditional costing systems are driven by the need to value stocks rather than to provide meaningful product cost.
5. Growing overhead costs because of increasingly automated production.
6. Overhead costs are no longer a mere burden to be minimized. Overhead functions such as product design, quality control, customer service, production planning, and sale order processing are as important to the customer as physical processes on the shop floor.
7. Complexities have increased. Product ranges are wider. Product cycle is shorter and demands the quality is higher.
8. The marketplace is very competitive.
9. Availability of Computer has enhanced requirement for improvement in information gathering Technology for advanced decision making to gain competitive advantage.
10. Decreasing costs of information processing because of continual improvements and increasing application of Information Technology.

The traditional overhead costs are grouped together under cost centre headings and then absorbed into product costs on the same basis. Whereas ABC focuses on the activities as fundamental cost objects and uses the cost of these activities as building blocks for comparing the cost of other objects.

‘Activity-Based Costing’ is an accurate method for the allocation of overheads, especially, when the manufacturing companies in the present business environment, where a wide range of product and customer prevails. Under ABC method, each and every activity is identified to be a separate cost driver and then the allocation is made accordingly.