Traditional costing accounting is criticized for its irrelevance and cost distortion during the last three decades (Management accounting, p. 217). To bring relevance and overcome these systematic distortions in costing, activity based costing was created to replace traditional costing. It is significant to note that a traditional costing system indicates what resources are spent on, but it did not take into account the cost of processes and activities. Many entities including semiconductor and petroleum organizations in the manufacturing industry have implemented activity based costing. Traditional costing bright about cost distortion because it combined all indirect costs into a one cost pool. ABC prevents cost distortion by adopting multiple activities (cost pools) and cost drivers. However, this paper seeks to discuss activity based costing, its concept, merits and demerits over traditional costing.
Activity based costing concepts
Activity-based costing is defined as the methodology for accurately allocating indirect costs (overhead) to the items that use them. The system is used for the targeted minimization of overhead costs. Activity based costing works excellently in complex environments characterized by many products and machines, and twisted processes that are more challenging to sort out. The cost drivers are pertinent to the activity based costing. Thus, a cost driver is any event or factor that causes the activity cost (Management accounting, p. 218). Activity based costing establishes the casual relationship between cost drivers and activity that facilitates management to concentrate their improvement efforts on those departments or areas that generates best outcomes. Additionally, activity based costing can be understood through different steps. The most important step in activity based costing involves the identification of the costs that needed to allocate to the activities that use them. This is the most important step in activity based costing process. The next step is to establish cost pools or activities to the identified costs. Once the cost pools are established, the activity drivers are measured through the data collected about these activity drivers.
The logic of activity based costing
The logic of activity based costing lies in designing the product that produces activities that need resources and this generates costs. According to The Economist (2009), the activity based costing logic is that organizational resources produce costs, activities uses resources and the products uses activities. Activity based costing is an accounting approach that permits organizations to collect data about the operating costs and their allocation to the needed activities to produce the product. The approach assigns overheads to the cost items which includes products and services or even customers reliant on activities an organization performs. It is significant to note that costs of resources are allocated to the activities that the actual cause of the indirect costs, and then the cost of activities will be consumed to generate the demanded product. The activity based costing is the two-stage logic process where the first stage involves costs of resources allocated to activities that uses these resources; and the second stage involves linking the costs to activities that are allocated to cost products that consume the activities.
Implementation of activity based costing
Organizations with efficient costing systems are capable of designing products or services that satisfies the expectations and at the end, generates profits. The implementation of ABC requires the use of software. For example, ABB, a Swiss-Swedish Company, uses ABC software to change the manner in which costs are allocated (The Economist 1b). The design of activity based costing model seems less complex, especially when the company knows the actual cause of costs. The implementation of activity based costing involves four steps: identifying activities; allocating resource costs to the identified activities; selecting cost drivers; and assigning cost of the activities to finished products or services (Management accounting, p. 220).
Merits of activity based costing
The ABC concepts indicate that products or services are allocated cost of activities undertaken pt product the output (The Economist 1a). One of the merits of cost based costing is that it allocates indirect costs to activities in a more exact manner since it identifies activity costs associated with cost drivers. Most companies use activity based costing approach because it is more accurate than tradition costing. By using ABC, manufacturing companies can identify those activities that make the production process expensive. The resources are allocated to only those activities that produce the product and this creates value and strong position in the market. ABC also minimises wastage since the company is able to avoid irrelevant activities.
Demerits of activity based costing
Some companies are considering activity based costing to be expensive to implement and maintain since it requires the use of software and engineering data. The activity based software is expensive and difficult to integrate. It is a time consuming process as the activities are divided into their discrete form and data collected to enable measurement of costs. Some of the organization costs are common costs and it is not possible to divide them to allocate them to product in a straightforward way. Another bottleneck of activity based costing is that it is difficult to find homogeneous activities. In ABC, activities can only be homogenous for them to be assigned to their respective cost drivers. Failure to use homogeneous activities, the results would be inconsistent and the company would be compelled to divide these activities into discrete ones. For example, healthcare overheads are too complicated; and because patients have different needs that do not fit to standardized unit of care and time, the time- driven ABC implementation process is inconsistent (Beck 1).
Conclusion
In conclusion, the activity based costing is more accurate in cost allocation than traditional costing. It allocates the resource costs to those activities that use them, known as cost drivers. Due to its accuracy, many manufacturing companies such as semiconductor and petroleum organizations are implementing ABC. ABC minimizes waste of resources by allocating resources to activities that are relevant to production of products or rendering of services to customers. However, some companies have not implemented ABC because its implementation is expensive and complex. Activity based software is very expensive and complex to integrate to the company’s activities. Some activities are indivisible since their resource cost consumption is not easily identifiable.
References
- Beck, Melinda. Searching for the True Cost of Health Care: Providers Look to Cut Waste
- With Detailed Cost Tracking. The Wall Street Journal, 2014. Available at: http://www.wsj.com/articles/SB10001424052702304888404579379122507671850
- Class book: Management accounting
- The Economist (a). Activity-based costing. The Economist, 2009. Available at: http://www.economist.com/node/13933812
- The Economist (b). Cost-cutting activity. The Economist, 1998. Available at: http://www.economist.com/node/170157
