Question

Companies usually, in pursuit of refining their costing system, adopt Activity-Based Costing systems with an aim to arrive at accurate cost figures. Describe, in your own words, the prominent factors/reasons (any four) that contribute to these companies’ taking such initiatives. That is, what are the main factors that are causing these companies to consider refining their costing systems?

Answer 1

Traditional overhead apportionment (Traditional Costing system) believes that departments are responsible for costing incurrence and hence cost driver for departments were identified e.g.., a machine department uses machine hours as cost driver, an assembly department which is labour dominated uses labour hours as cost drivers.

However, ABC recognizes that departments are not responsible for cost incurrence but it is the activities performed by departments that causes cost to be incurred. Thus ABC uses cost drivers to assign overhead cost to the cost objects.

Due to using of Traditional Overhead process, the overheads are wrongly apportioned to the respective products which in turn increases the cost of the product and misleads the management in discontinue the product even though the product is considered Viable.

In the case where products are highly differentiated involving different level of complexities, traditional costing system leads to under or over costing of products which can have adverse pricing and profit implications. Due to this company may fix more price for one product which will result in low volume of units sold and makes the low price for the other product which will result in selling more quantity due to lower price. As a result, cost for producing it also increases and these costs cannot be recovered through A due to low demand this makes the companies in refining their costing system

Company following traditional costing system will not get any benefit through value engineering process for cost reduction.