Question

Activity-based costing systems are quite complex with each activity cost and department usually getting a lot of attention. What are the most important factors in developing cost factors for each activity?

Despite all the analysis usually done, such cost systems tend to inaccurately assign too much overhead in certain circumstances and too little overhead in others.

Why might that distortion occur?

How might understanding the hierarchy of activities help explain how to combat this trend?"

Answer 1

Activity-based costing (ABC) is an accounting method that identifies and assigns costs to overhead activities and then assigns those costs to products. An activity-based costing (ABC) system recognizes the relationship between costs, overhead activities, and manufactured products, and through this relationship, it assigns indirect costs to products less arbitrarily than traditional methods.

The most important factors in developing cost factors for each activities are:-

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.

ABC produces reliable and correct product cost data in case of greater diversity among the products manufactured such as low-volume products, high-volume products. Traditional costing system is likely to bring errors and approximation in product cost determination due to using arbitrary apportionment and absorption methods.

2. Information about Cost Behaviour:

ABC identifies the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product. With ABC, managers are able to control many fixed overhead costs by exercising more control over the activities which have caused these fixed overhead costs. This is possible since behaviour of many fixed overhead costs in relation to activities now become more visible and clear.

3. 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.

4. Tracing of Overhead Costs:

ABC traces costs to areas of managerial responsibility, processes, customers, departments besides the product costs.

“Despite all the analysis usually done, such cost systems tend to inaccurately assign too much overhead in certain circumstances and too little overhead in others”

Reason:-

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.

3. Disadvantages to Smaller Firms:

ABC has different levels of utility for different organisation such as large manufacturing firm can use it more usefully than the smaller firms. Also, it is likely that firms depending on cost-plus pricing can take advantages from ABC as it gives accurate product cost. But those firms who use market based prices may not favour ABC. The level of technology and manufacturing environment prevailing in different firms also affect the application of ABC.

4. Measurement Difficulties:

The main costs and limitations of an ABC system are the measurements necessary to implement it. ABC systems require management to estimate costs of activity pools and to identify and measure cost drivers to serve as cost allocation bases. Even basic ABC systems require many calculations to determine costs of products and services. These measurements are costly. Activity cost rates also need to be updated regularly.