Activity based costing is an accounting costing model in which an organization or a firm assigns costs of activity resources to all products and services manufactured or produced depending on the percentage the service or product consumes. Through this, model accountants assign more overhead or indirect costs into the direct costs of the products. It is an alternative to the popular traditional mode of accounting. ABC as a costing model identifies an organization's activity centers (cost pools) and assigns cost drivers determined by the number of transactions or events that lead to the provision or delivery of a service or product. The traditional accounting method is based on the assumptions that; profitable customers are those who purchase big volumes, loyal customers are profitable ones and that profits follow happy customers. Several studies showed that, that was not necessarily true and thus there was need to look for a better way to determine profitability. This led to realization of Activity-based costing as an accounting model. Despite this fact, it is also true that indirect or not all products or services caused overhead costs equally. Thus, it was inaccurate to apportion the same amount of overhead costs to all products and services. For example Lets assume that Khaled Abdallah limited is a company that produces three different products A, B, and C. lets assume that the data below relates to its costs transaction cost drivers and volume for the financial period ending 30th
November 2010.Given this information, let us assume that the company has the following overhead costs associated with its operations.With this kind of a situation, it is inaccurate to apportion the same machine costs to all three products since each of the product uses different machine hours to be manufactured. This realization caused the Activity-based costing to be developed in the United States' manufacturing sector between the 1970's and 80s. George Staubus spearheaded it. In the presence of multiple products, managers were making inaccurate estimates of costs. ABC was defined clearly in 1987 by Kaplan and Bruns and later explained in detail in 1999 by Peter Drucker (Kaplan & Bruns, 1987 Drucker, 1999).Differences between ABC and traditional cost accounting methods
The main and most obvious difference between Activity-based costing and the traditional cost accounting is that ABC is complex or difficult whereas TCA is simple or easy. Secondly, traditional cost accounting was designed and developed between 1870 and 1920 whereas Activity-based costing was introduced in 1981. In the TCA system, the cost objects as well as the used up resources are needed for the evaluation of costs while in the ABC system the cost are dependent on the activities used up by the cost objects.Activity Based Costing is considered accurate and preferred over the TCA cost management system. Traditional Cost Accounting uses a single overhead or indirect cost pool and is not able to calculate the true cost this is not so with ABC system (Ibid).Why ABC has grown in importance in recent decades?
Over the last few couple of decades, ABC accounting system has increasingly grown in importance when compared to the traditional cost accounting system. The reasons behind this include the changing requirements for accounting standards as well as shareholder specific needs.With Activity-based accounting, many firms or organizations have been able to become more competitive globally. In addition, this model is favored since it represents the actual costs of all products or services. With this information, accountants and financial analysts identify and eliminate services or products that are not profitable to the business entity. Activity-based costing also enables accountants to formulate an acceptable pricing policy for the firm since from the distributed costs; accountants know overpriced or under priced services and or products. With this information at hand, accountants can either reduce or increase prices of their products or services in order to make them competitive in the market.Using data derived from services provided to clients or customers, the ABC approach helps an organization allocate resource costs accurately. A clear understanding of the products, customer costs and profitability is required in order to make the ABC model successful.The benefits of using Activity-based costing
a) Helps the firm to make informed decisions concerning outsourcingb) Gives a platform for the identification and measurement of development and improvement initiatives for the services or productsc) It helps to determine unnecessary costs within an accounting entityd) Helps in making or changing pricing strategiese) It helps accountants to identify inefficient products, services, departments and product development activitiesf) In relation to (d) above it helps in the allocation of more resources to profitable services, products, departments and product development activities while at the same time doing the vice-versa for unprofitable or loss-making onesg) It helps in cost control at an individual level as well as on a departmental levelh) It helps to achieve a better positioning of company products in the marketi) It enhances the firm's bargaining power with respect to its customersj) It helps to determine the detractors and contributors to a firm's financial performancek) It helps to determine the underlying factors for poor or deteriorating financial performancel) It equips managers with a tool to maximize the value of shareholders as well as improve the company's corporate performance.Disadvantages/Limitations of using Activity-based costing
a) Implementing an ABC system is a big project that needs many resources. Once in place the system is still expensive to maintain. On top of this Data concerning the numerous activity measurements must be collected, verified, and entered into the system.b) ABC produces figures like product margins that are dissimilar to those produced by traditional costing systems. This is a limitation because managers are accustomed to using figures or numbers generated using the traditional cost accounting system to make managerial decisions.c) Data generated with the Activity-based costing system is not used for performance evaluations.d) Reports generated by this system do not conform to generally accepted accounting principles (GAAP).as a result, an organization involved with the use of activity based costing should have two cost systems - one for internal use and the other for preparation of external reports. This is not only time consuming but it also draws more resources from the organization.Implementation of ABC
It is necessary that before an organization makes the decision to implement the ABC system, there be agreement between the shareholders and company managers to avoid quarrels later on. It is not recommended for all companies to implement the ABC accounting system. However implementing the ABC accounting system is recommended where the following factors are evidentIn cases where the company has grown and products start to differ significantly both in manufacturing complexity as well as in volumesThe Activity-based costing system is recommended where a company's product lines are many, diverse and require different degrees or types of support services.The ABC system is also recommended when the company's overhead costs represent a substantial or significant percentage of the company's total costsThe ABC system should also be implemented when marketing and/or production managers ignore or do not value data provided or derived from the existing traditional cost accounting systems.Activity based costing does not follow the traditional accounting methods. Many have even claimed that Activity-based costing is much more complicated and expensive to follow. Activity-based costing allows for Continuous Improvement. This is because company employees now understand or comprehend the various costs divisions that are involved. With ABC employees are empowered to enable them analyze associated costs, identify activities, which add value, to the products or services and those that do not add value.