Activity based costing (ABC) is a relative new way to allocate costs to specific processes and services. This system assures that the costs are accurately distributed to the products or services that generated them. ABC illustrates costs more accurately, giving management insight to the cost associated with certain business activities. ABC extends the decision-making skills of management by expanding on traditional costing (job order costing/process order costing) techniques. However, since ABC’s introduction in the 1980’s, many corporations are not using ABC, despite gained managerial decision making capabilities.
Even by the mid-1990s, ABC’s use has not spread throughout the accounting industry and its use is not obvious (Selto & Jasinski, 1996). The following article will discuss the pros and cons of the ABC method. Traditional Techniques ABC is an extension of traditional product costing techniques. These techniques are called job order costing and process order costing. A job order costing system arranges costs for each unit as it goes through a production process. A process cost system collects costs in work in progress account.
The numbers of units worked are recorded for the accounting period. These systems alone do not accurately illustrate costs incurred. Instead, these two costing techniques generally lump costs into 3 main categories (cost centers). These three categories are direct materials, direct labor and overhead. Cost drivers are then assigned to represent the relationship between the cost and the process it is allocated to. Activity Based Costing ABC provides a better map of the costs of manufacturing products or distributing services.
ABC uses a multitude of activity centers, which are the equivalent to the previously mentioned traditional cost centers. Each of these activity centers has its own cost driver and driver rate. ABC identifies many different costs to products by adjusting the cost driver and driver rates to specific activity centers. This process avoids across the board allocations of cost. For example, a product, which takes up . 03% of space in the warehouse, would require . 03% cost absorbed by product sales revenue.
If the depreciation unit requires 5% cost to replace equipment at a latter date, 5% is the driver rate for that particular product. Unit, batch and product level costs can be determined with ABC. The following steps can summarize the ABC process. The first step is to identify the activities that consume resources and allocate costs to those activities. For example, purchasing materials, record keeping, labor, materials, miles driven, machine hours and number of customers served are activities, which consume resources and needs costs to be assigned to them.
The second step is to distinguish the cost drivers that are related to each activity. For example, if machine hours an activity used in the process, then the number of hours used in production of one unit would be the particular cost driver rate. The last step is to allocate costs to products by multiplying the cost driver rate by the number of cost driver units consumed by the process. Pros There are many inherent strengths in the ABC model. The ABC model allows costs to be allocated to many different activity centers. Few corporations can focus on undifferentiated product lines and be successful.
Having multiple product lines means the company has multiple cost drivers associated with each different product line. ABC is helpful in selecting which products are successful and which ones should be eliminated. Accurate cost information is key in determining the actual costs of frequent product changes. This cost is important because costs can be a good indicator of the justification or termination of varying product lines. Product lines have become more complex. Product lines of past were much simpler. For example, the Model T Ford came in one style and one color, black.
Today, Ford cars have many different colors and styles. These different styles all have different cost drivers and activity centers. ABC illuminates hidden costs when high volume sales are not present and product differentiation is. This is advantageous because unprofitable lines can be replaced with lines that are profitable. Not many years ago, labor comprised 25 to 50 percent of a product’s cost. However, since the 1960s, labor is increasingly less involved in the production process. For example, the textile industry replaced 100-year old shuttle looms for European air-jet looms, doubling output with less labor.
In steel, the Nucor corporation used continuous casting machines to yield labor costs of $60/ton verses traditional steel’s $130/ton. Labor cost today is infrequently the driving force behind costs it was during the development period of cost accounting (1930’s). Instead, indirect costs have replaced labor as the dominant portion of costs for some products (Kelly, 1991). To use labor as the major basis for allocating as job costing or process costing accounting does, may lead to inaccurate decisions by management. Cons
The accounting profession has largely overlooked ABC. Among reasons cited for low adoption were employee resistance and the organizational changes essential with the use of ABC (Ness & Cucuzza, 1995). Some trace the source of hindered adoption of ABC to technical as well as cultural issues. Others feel that ABC would be more widespread in industry if it were marketed better by the accounts themselves (Brausch, 1992). There are several reasons for ABC low adoption rate. Complexity is an obstacle to implementing ABC.
ABC requires detailed records of the costs associated with producing products and services as compared to traditional methods. This detailed record keeping requires more effort from the accountants and is more time consuming. The complexity of ABC can contribute to more errors. ABC can require more time to check and recheck to uncover errors. ABC generally requires more effort on the part of the accountant verses traditional methods and reduces the adoption rate of ABC. Another reason for not using ABC is the increased economies of scale.
Many corporations are standardizing their products to reduce the costs to manufacture them. For example, Coca-Cola distributes its products in many different countries. The product varies very little in respect to packaging and manufacturing. Traditional methods of accounting can assign costs more easily, quickly and accurately for those products that have little or no product variation. Conclusion ABC is a valuable tool in calculating the costs of producing varying product lines. These differing product lines require more extensive accounting practices than traditional costing methods provide.
The information obtained from ABC can help promote product lines that managers feel are profitable between those which should be eliminated. Labor is less frequently the major ingredient in the production process. ABC addresses this concern by examining and illustrating the overhead costs associated with particular activity centers. ABC describes these over head costs more accurately and is beneficial when increasingly more complex manufacturing processes are used. Adoption issues should be addressed to implement ABC method when costing decisions matter to managers.