Activity based costing [ABC] is a costing method that was developed to counter the potential weaknesses of other costing methods. More traditional costing methods tend to look at overhead costs being driven by the scope of production being performed. Machine hours, worker hours, and unit costs would calculate costing. Because the process of production has evolved over the years, the complexity and diversity of products has changed and that brought about ABC.
These activity based costing advantages and disadvantages show that it may be an appropriate costing method at times, but traditional costing methods may also be useful in some ways as well. Here are some of the key points to consider.
The Advantages of Activity Based Costing
1. It provides a more accurate cost per unit.
Because there is more accuracy in the costing, using ABC can help provide better pricing and sales strategies. It also improves performance management policies and allows for those involved to make better decisions because their information is more accurate.
2. It allows for deeper cost insights.
ABC takes a more detailed look at what is driving overhead costs. Because of this, a deeper insight into what may be holding production or sales volume back can be obtained. This allows for a faster response time to potentially troubling issues so cash can be saved. Not every cost is related to sales or production.
3. ABC can be applied to all overhead costs.
You’re not just stuck with production overhead costs like you are with traditional costing methods. Activity based costing is based on the overhead of everything that you do. This allows you to determine realistic costs in a business environment which is increasingly complex, which can help you to become more competitive within your niche or industry.
4. It can transfer over to service costing.
ABC is versatile. It can be used to determine a significant portion of your total costs instead of specific costs that may be affecting your bottom line. It is controlled by managing cost drivers as well, which means ABC can help managers understand what is driving cost and how to fix it in a much more reliable way.
5. It provides quantifiable figures.
This makes it a lot easier to complete the planning process and to create future estimates.
The Disadvantages of Activity Based Costing
1. It can be difficult to explain to those who are invested into the process.
ABC can be particularly problematic to stakeholders who have equity shares in a business, but are not actively involved with it. Because the costing takes more information into account, the data that is brought forward can make it seem like activity based costing is taking away profits instead of saving them.
2. It may have limited value for some organizations.
If overhead is a rather small proportion of the overall costs a company is facing, then ABC will not be as effective. This is also true if a company has overhead costs that are related to volume primarily instead of production. Considering it is virtually impossible to allocate every single overhead cost for every specific activity that may need to be performed, it could be argued that ABC leads to inaccurate data instead of better data.
3. The cost of implementing ABC might not justify its cost.
Your entire accounting structure must transition to ABC if this was not the costing method used in the first place. Because of this, there may be carryovers, depreciation, and other costs that must be fully capitalized in order for the transition to take place. Because of this, it may not be cost-effective to make an immediate transition to this costing method even if it can provide immediate benefits.
4. ABC typically requires other systems to be changed as well.
This is particularly true for how variances may be calculated. When activity levels are more or less than anticipated, then ABC requires a direct activity cost comparison to determine what the variance will be. This may then create a chain reaction where efficiencies are also affected.
5. Assigned costs are ultimately an estimate.
To create a budget, ABC requires you to assign the cost of products and services based on an estimate of overhead costs to direct costs. If the estimates are inaccurate, then your costing is going to be problematic.
These activity based costing advantages and disadvantages show that this costing method can be beneficial for the complex modern production models that exist today. It may not be right for every business, however, so evaluate each key point and make sure the benefits outweigh the costs before implementing a costing change.