Activity-based costing (ABC) is a useful costing method that accounts for overheads and indirect costs. It allocates costs through identifying cost activities, cost drivers, and cost pools.
The ABC method removes several inefficiencies in the traditional costing approach. However, the approach requires effective implementation and change management to achieve efficiency.
Let us discuss what is activity-based costing and what pros and cons it brings to a company.
What is Activity-Based Costing?
“Activity-based costing is an approach to the costing and monitoring of activities, which involves tracing resource consumption and costing final outputs. Resources are assigned to activities and activities to cost objects. The latter use cost drivers to attach activity costs to outputs” – CIMA Official Terminology.
Activity is any task that is carried out to produce a product or service. A cost driver is a factor that links activity resource consumption to the product output.
Following the approach of identifying activities and assigning costs through cost drivers, the ABC method includes direct and indirect costs related to production.
ABC method focuses on including overheads and indirect costs of production. It identifies these costs so that they are assigned more specifically than in a traditional costing approach that generally distributes these costs.
Identifying and assigning costs based on cost drivers and activities to help management in several types of analysis. These analyses can include product costing, product pricing, customer profitability, product profitability, and so on.
Problems with Traditional Costing Methods
The traditional costing approach follows the notion that overhead costs are derived by the production level. Typical measures or cost drivers were labor per hour or machine hours.
Automation and customization of products have altered the manufacturing processes. Manufacturing has become more machine-intensive than labor-intensive as in the past.
It means overheads have a bigger proportion in the production costs than earlier. Thus, a manufacturing facility must recognize these overheads that affect several decisions and ultimately the profitability of the organization.
Some overhead costs such as product engineering, design, and marketing are clearly directly attributable to a particular product. These costs will be significantly higher for a customized product.
Another key challenge with traditional costing comes through indirect cost allocation on the product volume basis. It means in a multi-product facility there would be cost allocation distortions. Inevitably, some products would consume less indirect resources and others will consume more.
Activity-based costing addresses both of these main issues of the traditional costing approach.
Activity-Based Costing Process
The activity-based costing process takes a step-by-step approach to cost allocation. Broadly, the process can be divided into five steps.
Step 1: The first step is to identify all activities required to produce a product. These activities can then be identified through cost pools.
Step 2: The second step is to identify the cost driver for each activity. A cost driver is known as a factor that causes the cost for each activity.
Step 3: Next step is to calculate the cost driver rate by dividing the total cost for an activity divided by the total cost drivers.
Overhead costs can be calculated for each activity separately in this process.
Step 4: In this step, driver cost rates are absorbed back into individual products.
Step 5: The last step is to calculate the total cost per unit by adding costs of all activity costs identified above.
Challenges with the Implementation of Activity-Based Costing
Activity-based costing brings substantial benefits to any organization. However, the implementation comes with several challenges for the management and employees.
Lack of Management Support
A lack of management support may come due to several reasons. The prime cause is the top management considers the ABC system at par with other costing systems. Thus, they do not see any perceived benefits coming through the ABC method.
Employee Resistance
Along with the top management, employees of the company may also pose resistance. Particularly operational managers that would need to spend substantial time and effort.
Lack of Technology and Resources
ABC system requires significant resources and is costly than traditional costing methods. It also requires significant technology resources. Thus, many small and medium-sized businesses cannot afford to implement the ABC system.
Lack of Communication
Another challenge is to communicate the change effectively. The adoption of the ABC method requires behavioral change management. A lack of communication cannot bring benefits and can result in a failed attempt to implement the ABC method.
Application of Activity-Based Costing
Activity-based costing can be implemented across the organization for its various functions. The approach of activity-based costing can be replicated in different business aspects.
Budgeting
Activity-based costing provides an excellent foundation for the activity-based budgeting (ABB) approach. The management can identify levels and costs of activities that match the budgeted quantity and quality of production.
Like ABC, the ABB is a systematic approach. It brings results when adopted as a culture rather than only a process.
Cost Modelling
The application of ABC can bring cost allocation at the unit level, batch level, product, customer, and facility level. It brings a complete cost modeling framework.
A core advantage of the ABC approach is that it offers a long-term perspective for decision-making.
Customer Profitability Analysis (CPA)
Activities and cost drivers can be assigned to customers as well. It brings customer profitability data that can be used for better pricing and product customization.
The CPA can help management with key decisions such as customer service costs, product, and service customization, introducing new products, abandoning unprofitable products and customers, and so on.
Product or Service Design
In a production facility with similar products and little customization, the ABC can help management in new product design as well.
The management can use existing product activity costs and estimate the cost drivers for the new product or service.
Product Pricing
Traditional costing does not offer comprehensive costing information about products manufactured in the same facility.
The ABC method helps identify costs associated with each product. Thus, it helps management in identifying the true costs of a product to make better pricing decisions. That in turn will lead a business to remain competitive or even gain a competitive advantage.
Product Output Decisions
Analyzing activities and cost drivers can help management in identifying several key product output decisions.
These decisions can include product volume levels, controlling input (component or raw material) costs, keeping or dropping a product line.
Pros and Cons of Activity-Based Costing
As we discussed, activity-based costing is a comprehensive costing approach that offers several benefits to a company. The approach can be applied across different business functions.
Pros Explained
Better Decision-Making
The biggest advantage of adopting the ABC system is that it helps in better decision-making. Identifying cost drivers, activities, and cost pools leads to the better product cost and pricing decisions.
It includes factors such as including indirect costs that help management make better decisions regarding operations.
Better Profitability
Better insights into production costs mean better decisions. It means higher profitability for the business.
Using the ABC method means a business can stay competitive with its pricing, thus bringing more sales. It can help a business in taking a competitive advantage as well.
Improved Processes
Adopting the ABC system also helps in improving the overall operating efficiency of a business. The business can improve core activities that derive higher costs.
Successful implementation of the ABC method will mean changing to a continuous improvement environment. Thus, an organization operating under the ABC system will seek continuous process improvements.
Calculating the Cost of Unused Capacity
Cyclic and seasonal sales mean fluctuating product demand. It leads to unused resources and production capacity.
The management can make wrong pricing decisions in such situations. ABC system helps the management in identifying and assigning costs of unused capacity. Thus, it helps in making better pricing decisions in these circumstances.
Uniform Implementation Uniform Implementation
Another key advantage of the ABC system is that it can be implemented across several business functions. It is a holistic approach that can help management in achieving successful results through uniform implementation.
Cons Explained
Cost Constraints
Activity-based costing is a comprehensive approach that requires significant resources. Thus, implementing the system can be costly for any business as data collection, processing, and analyzing takes substantial resources.
Cost constraints are particularly higher for small and medium-sized businesses.
Technology and Skill Requirements
Development and Implementation of the ABC system for any organization require specific skills. Cost accountants must possess sufficient knowledge and expertise to exercise the ABC approach.
The sophisticated and complex ABC process also means an entity will require technology advancement as well.
Misinterpretation of Results
Although deemed useful, the information offered by the ABC system is partially relevant for the decision-making process.
Moreover, processed data and information must be interpreted carefully. The management can easily misinterpret the results achieved through the ABC method.
Behavioral Change Management
Adopting the ABC method can lead to resistance from operational and top management as well. ABC system is a holistic approach that requires behavioral change management.
Concluding Remarks
Activity-based costing is a useful costing alternative to the traditional costing approach. It identifies activities, cost pools, and cost drivers that are responsible for incurring production costs.
The ABC approach includes indirect costs and overheads that have become a significant portion of the total product costs in modern times. Thus, it offers better product costing and pricing decisions.
When implemented across the board, the ABC system can bring process improvement, operational efficiency, competitive advantage, and better product/customer pricing decisions.
The hurdles with the ABC system implementation are prominent too. It requires across-the-board implementation and behavioral change management for successful results.
