Question

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Is ABC info always better than Average-cost? No… not always. ABC costing will surely be more detailed and most likely more accurate, however will an organization's benefits of ABC outweigh the added intricate, time consuming costly characteristics?

One factor to consider in this would be the amount of overhead costs an organization tends to operate with. ABC should be used "when overhead is high, because small changes in each product cost can make a large difference overall." A company who produces one single product would likely have low overhead as most of the costs would be direct costs associated with the single product. In this situation, ABC benefits would not outweigh the costs and time required to produce ABC information.

“While ABC isn't allowed for external financial reporting, companies may find it useful to enact an ABC system to more effectively analyze cost data.” Since ABC does not conform to GAAP for external reporting requirements, a company essentially has to report on costs twice. It’s important for organizations to consider the added time and cost of now reporting two different ways.

Answer 1

Activity based costing (ABC) is a costing method that is designed to provide managers with cost information for strategic and other decisions that potentially affect capacity and therefore "fixed cost".

Activity based costing system is used to determine product costs for special management reports. This system is ordinarily used as a supplement to the company's usual costing system. Most organizations that use ABC system have two costing systems - the official costing system that is used for preparing external financial reports and the activity based costing system that is used for internal decision making and for managing activities.

In traditional cost accounting systems, the objective is to value inventories and cost of goods sold for external financial reports in accordance with the generally accepted accounting principles (GAAP). In activity based costing (ABC) system the objective is to understand overhead and the profitability of products and customers and to manage overhead. As a consequence of these differences in objectives, "best practice" activity based costing system differs in a number of ways from traditional cost accounting.

In activity based costing:

1. Non-manufacturing as well as manufacturing costs may be assigned to products.
2. Some manufacturing costs may be excluded from product costs.
3. A number of overhead cost pools are used, each of which is allocated to products and other costing objects using its own unique measure of activity.
4. The allocation bases often differ from those used in traditional costing system.
5. The overhead rates or activity rates may be based on the level of activity at capacity rather than on the budgeted level of activity.

These differences from traditional cost accounting systems can dramatically impact the apparent costs of products and the profitability of products and customers.

Since activity based costing (ABC) system generally provides more accurate product costs than traditional costing methods, why isn't it used for external reports?

Some companies do use activity based costing in their external reports, but most do not. There are a number of reasons for this.

1. External reports are less detailed than internal reports prepared for decision making. On the external reports, Individual product costs are not reported. Cost of goods sold and inventory valuations are disclosed, but their is no breakdown of these accounts by product. If some products are under-costed and some are over-costed, the errors tend to cancel each other when the product costs are added together.
2. It is often very difficult to make changes in a company's accounting system. The official cost accounting system in most large companies are usually embedded in complex computer programs that have been modified in-house over the course of many years. It is extremely difficult to make changes in such computer programs without causing numerous bugs.
3. An ABC costing system does not conform to generally accepted accounting principles (GAAP). Product cost computed for external reports purposes must include all of the manufacturing costs and only manufacturing costs; but in ABC system products costs exclude some manufacturing costs and include some non-manufacturing costs. It is possible to adjust the ABC data at the end of the period to conform to GAAP but it requires more work.
4. The auditors are likely to be uncomfortable with allocation that are based on interviews with the company's personnel. Such objective data can be easily manipulated by management to make earnings and other key variables look more favorable.

So,for all of these reasons, most companies confine their ABC efforts to special studies for management, and they do not attempt to integrate activity based costing into their formal cost accounting system.