Activity Based Costing

Activity-based costing (ABC) employs numerous cost groups, organized by activity, in the allocation of overhead costs. The conception is that activities are necessitated to generate products, basically activities, such as procuring materials, setting up machinery, assembling products, and scrutinizing finished products. It is imperative to note that these activities can be expenses and therefore the cost of activities ought to be apportioned to products on the basis of how the products use the activities. The costs are placed on the products on the basis of the use of individual products for every activity (Hansen et al., 2007). In the traditional product costing system, to begin with, costs are not linked or mapped out to activities but they are rather traced to a unit within the organization, for instance a department or a division, and thereafter to products. This implies that in the traditional and ABC costing systems, the second as well as finishing stages are made up of linking costs to the product. Nonetheless, by laying emphasis on activities, the activity-based costing system attempts to determine the factors that cause every key activity, cost of these sorts of activities and the association between activities and the products produced (Lal, 2009). The purpose of this paper is to discuss the theoretic shortcomings of activity-based costing and the decision encompassed on the manner in which cost drivers are chosen for an activity.

Without doubt, activity-based costing provides better cost information in comparison to majority of traditional approaches of costing, for instance department and plant wide allocation approaches. Nonetheless, ABC does have its weaknesses and shortcomings. To begin with, activity-based costing systems can be costly and expensive to carry out. In particular, ABC systems necessitate collaboration and coordination across the organization, and as a result necessitate personnel to take breaks and time off from their everyday activities to provide assistance in the ABC process. In addition, apportioning activities takes time and so does the ascertaining and tracking of cost drivers. Moreover, apportioning cost to the firm products necessitates a substantial amount of time within its accounting division (Heisinger, 2009).

A second weakness of the ABC system is the aspect that its centralizing of fixed costs is deceptive and distorted. Product costing takes into account apportioning costs from activity centers to products and computing product cost per unit. The weakness and shortcoming to this method is that fixed costs are more often than not a major part of the overhead costs being apportioned. Examples of some of these fixed costs include salaries and depreciation for buildings and machinery. It is imperative to note that fixed costs are the outlays that remain constant in total with changes in activity. For instance, in using activity-based costing assume that a company incurs $10,000 per unit to produce 2,000 units. In the event that the firm produces 4,000 units, the unit cost is not expected to remain constant at $10,000. Imperatively a substantial percentage of overhead expenses are fixed and as a result will be spread out over the increased number of units, which will cause a decline in the cost per unit. Therefore, the shortcoming of the ABC system is that it will offer misleading information regarding decision making, especially if the form expected a significant change in the level of production (Heisinger, 2009).

In accordance to Bendrey et al. (2003), another theoretical flaw of activity-based costing is the necessity of more detailed analysis. In comparison to the absorption costing approach, the ABC approach necessitate a more comprehensive analysis of cost drivers and cost pools, with a resultant increase in the cost of running the accounting system. Moreover the approach requires additional simplification. In particular, the aspect of ascertaining cost pools and cost drivers is not always an easy and direct undertaking. At times, it is essential to vindicate and give a good reason for the number of cost pools and cost drivers aimed at diminishing the intricacy and cost of the activity-based costing system. This may be considered to be a weakness to the ABC system. Moreover Bendrey et al. (2003) indicate that the ABC system has a weakness in the lack of conformity to SSAP 9. In particular, the ABC system reassures all costs, comprising selling and distribution costs. This aspect encompasses and spreads across the standard foundation for prizing stocks for financial accounting reasons. SSAP 9 necessitates stocks as well as work in progress to be valued at complete production costs up to the phase of finalizing the end-product, which would generally disregard retailing and distribution expenses (Bendrey et al., 2003).

Another theoretical demerit of the activity-based costing system is that the approach has dissimilar levels of utility for dissimilar entities, for instance major manufacturing companies can employ it more efficaciously in comparison to smaller companies. In addition, there is a likelihood that companies that rely on cost-plus pricing can make the most of ABC method, owing to the fact that it provides precise and correct product cost. However, the companies that employ market-based prices may not have a preference for ABC method. The level and magnitude of technology and manufacturing setting existing in various companies also have an influence on the application and administration of ABC systems (Lal, 2009). Another major weaknesses of the ABC method is that its execution is largely costly. To begin with, setting up the system can be costly and time-consuming. With the analysist of activities for an organization, such activities must be further itemized into the individual constituents of every activity. The process, as a whole, can come to an end and deplete valuable resources as data is gathered, measured, and keyed into the new system. In addition, organizations may also need the help of a consultant that is an expert in setting up an ABC system and can offer training on its application and administration. The utilization of software can bring into play an extra expense for the execution and computerization of the manual elements that encompass using the activity-based costing system (Lal, 2009).

The ABC system is also considered to have a flaw as it misconstrues data. The information reported by an activity-based system takes into account data, for instance, product margins, which are completely dissimilar from the information that is produced by a traditional costing approach. Moreover, it is conceivable that a number of costs entailed in the ABC system may be immaterial and unrelated in particular decision-making instances. A very fitting illustration encompasses the sense that ABC does not comply with standards and, for that reason, cannot be employed by companies for the purposes of external reporting. Taking into consideration that traditional cost amounts and figures have a tendency of being the standard figures, construing and understanding data from the ABC system together with common accounting information can be perplexing, giving rise to an organization making poor decisions (Weygandt et al., 2009).

Execution of the ABC system is a cost assignment practice that consists of two phases. The first phase is the tracing of direct costs, which include direct labor and direct materials, to cost objects. In contrast the indirect costs are apportioned to activities through resource drivers. Moreover, these two stages of cost assignment takes into account using cost drivers that provide measures that are more accurate for product or services costs that are not relative to the volumes served or manufactured (Gill, 2015). Activity driver analysis ascertains the various factors that drive the different costs linked to an activity, and this enables management to assess substitute activity drivers that may be more cost effective with regard to labor, machine hours, as well as materials.

In the Activity-Based Costing approach, cost drivers are deemed to be the units that are employed to calmly apportion and trace indirect and mutual resource costs associated with various activities within the firm such as sales, administration and production. This is done on the supposition that cost objects, for instance orders, products and services, lay demand on resources. In keeping with this ABC approach, the products use up activities, and at the same time, activities use up resources. As a result, any factor that gives rise to an alteration in the cost of an activity or the extent to which the cost of an activity is used up can be referred to as a cost driver (Cokins and Capusneanu, 2010).

The first phase is identifying the cost object. In order to ascertain a cost driver, it is necessary to pinpoint a cost object. A cost driver is purposed to attain better distribution of the cost of a target cost object amidst its cost recipients. A very fitting example is an organization that goes through common material handling tasks; the manner in which it can better apportion its total material handling cost to various working units could be perplexing. In this case, the material handling cost is considered to be the cost object. Imperatively, by having the set target cost object, the organization has the capacity to ascertain a cost driver to assist in the distribution of the total material handling costs to various working units. The second phase is examining and scrutinizing prospective cost drivers. In the selection of cost drivers, a valid driver has to reflect and mirror the casual association between a distinctive activity and the cost that is experienced. Ascertaining a cost driver amongst prospective options is reliant on how effective every cost driver shows a relationship with a cost object, adds to management control and provides cost measurement (Way, 2017).

The third phase in choosing cost drivers for an activity is ascertaining cost driver relationship. A very fitting example is the material-handling example mentioned above. In this case, the management pinpoints two prospective cost drivers, recommending that material-handling costs for every working unit should be measured either by the number of boxes that are moved or the actual mass of the materials that are handled by a unit. It is important to note that, on one hand, if the materials handled are standardized, similar and packed in boxes of similar size, every unit would have an equivalent handling cost for each box of material handled. On the other hand, if the materials are dissimilar with regard to the size of packaging as well as the content, a unit that handles a huge box of heavy material has a probability of incurring a greater cost of handling, for instance, necessitating additional labor compared to a unit that handles a small box of light material (Way, 2017).

The fourth takes into account the management control effect. In particular, the selection of the fitting and suitable cost driver may have a constructive impact on management control. Based on the material-handling instance discussed above, in the event that the entire material handling cost is apportioned to individual working units on the basis of the number of boxes containing materials that are moved, a unit that handles several small boxes would then be apportioned to a greater cost than it actually expensed. In essence, this would give rise to one unit encumbering and subsidizing the cost of another unit. As a result, the small box would not have functioning stimuli for the reason that the more boxes it deals with, the more the cost it would fraudulently handle. This is a prospective issue regarding management control. It is imperative to note that utilizing material weight as the control driver permits equivalent and impartial cost circulation for all units (Way, 2017).

Finally, the aspect to take into consideration is cost measurement. In order to ascertain cost drivers, it is imperative for management to contemplate whether the cost measured as offered by a prospective cost driver is not only correct, but also simple to use. Despite the fact that utilizing the number of boxes to measure material handling is considered to be the simplest approach, employing it as a cost driver is neither trustworthy nor does it motivate positive working behaviors. Despite the fact that material weight is more precise as a cost driver, it could be sophisticated. This is in the sense that if a number of materials need better care than others, the same handling materials of similar weight might not be viable at the same cost. Nonetheless, to include an additional dimension, for instance the type of material to cost measurement, would make the apportionment of cost more challenging to carry out. The key reason why entities opt for cost drivers and cost accounting to manage costs is to have more efficacious utilization of restricted resources instead of dedicating additional resources to develop intricate cost measurement (Way, 2017).