Activity based costing methods and applications

Activity-Based Costing

This is a guideline and template. Please do not use as a final turn-in paper.

"Activity-based costing (ABC) assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities" (Accountingcoach.com, n.d., para. 1).

"Traditional accounting allocates a business's overheads (indirect costs such as lighting, heating and marketing) in proportion to an activity's direct costs. This is unsatisfactory because two activities that absorb the same direct costs can use very different amounts of overhead" (Economist.com, 2009, para. 2).

We will compare ABC to traditional accounting and formulate an opinion as to which one is more favorable for our global economy.

Robert Kaplan, a Harvard Business School professor, co-developed activity-based costing.

However, in an article published in 2005, Kaplan agrees that it has its shortcomings, and that, though it makes good theory and works in the classroom, it often does not succeed in the field.

The main criticism is that it falls short with large-scale operations. However, he suggests that the solution is not to abandon ABC. The co-developer of the process says, "ABC after all has helped many companies identify important cost- and profit-enhancement opportunities..." (Kaplan & Anderson, 2005, para. 1). And, in my research I found its success to be widespread.

So, Kaplan and Anderson have co-developed time-driven ABC (TDABC) to simplify the former ABC process. "In the revised approach," says Kaplan, "managers directly estimate the resource demands imposed by each transaction, product, or customer rather than assign resource costs first to activities and then to products or customers" (Kaplan & Anderson, 2005, para. 1).

One of the advantages of TDABC is that the manager can update the model based on actual events vs. estimating time spent on activities via employee surveys.

Traditional accounting, compared to either ABC or TDABC, would allow a large company that makes and continually updates customized products, and which bases its costs on historic data, to eventually incorporate large losses. For example, a mass-produced product can actually take the same amount of labor and materials that a customized product takes. But the customized product probably takes much more design and engineering time than the mass-produced product. Traditional costing systems would not, in most cases, pick up this difference.

With traditional costing a company that makes both low and high volume products might spread all of its overhead to products it manufactures based solely on machine hours. This might misallocate overheads between products. And if one product demands a significant amount of engineering, testing and setup, but the other does not, the result will be some level of miscalculation of overheads. ABC/TDABC overcomes this problem by assigning overhead on more than the one activity of machine hours. Activity-based costing recognizes that the special engineering, special testing, machine setups, and others are activities that cause costs -- they cause the company to consume resources (Accountingcoach.com, n.d., para. 2-3).