Activity Based Costing

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In the article written by David M.Katz on Activity-based Costing (ABC), it is agreeable that ABC has lost ground in the metric wars in recent years but it may be set for resurgence. Why? Firstly, let’s back date to the time when ABC arises in the world of accounting. In the early 1980s, ABC was introduced to overcome the growing dissatisfaction with the traditional ways of allocating costs. The problem with traditional costing method is it only assigns manufacturing costs to products - this includes direct material, direct labor and manufacturing overheads but it doesn’t allocate the indirect and support costs [1]. While manufacturing costs may be significant, there are many costs that relate to other facets of the business, including research and design, marketing, distribution and customer service. In today environment, direct labor now represents small fraction of corporate cost, while expenses covering factory support operations, marketing, distribution, engineering and other overhead functions have exploded [3]. Therefore, it is no longer justifiable to rely on the traditional allocation method which the product cost would not be accurate and eventually mislead the decision-making process. To illustrate, company nowadays no longer mass-produced their products but also started to customize their products to meet markets’ demands therefore, the traditional standard cost systems no longer reflects the economic reality. Companies were now operating with distorted information about the profitability orders, products and customers [2]. For example: while traditional cost system shows that all customers were profitable, the economic reality was that the customized products would be grossly undercosted while the simple products were being overcosted even though it would incur less labor cost because the labor cost consumed by the customized products would be higher. This resulted in the inaccurate profit determination for the products or particular department and led to the wrong decision-making in terms of the continuation, expansion of the company.

ABC then came into picture as the solution to the traditional cost method limitation; it is a method for determining accurate cost [11]. It solved the inaccurate allocation of overhead from traditional cost system by tracing indirect and support costs to the activities performed by the organization’s shared resources, and then assigning the activity cost down to orders, products and customers on the basis of the quantity of each organizational activity consumed [10]. ABC insists upon explicit cause and effect connections between the various activities and costs (or consumption of resources) as the first stage; then the second stage is to assign costs to objects involving the linkage of objects to activities through the use of activity cost drivers [8]. Simply, it means that the cause-and-effect relationship is direct and clear: the heavier the usage, the higher the total costs. ABC provides accurate information about the true cost of products, services, processes, activities and customers [1] and allows a better and more comprehensive understanding of overheads and what causes them to occurs. It also makes costly and non-value adding activities more visible and thus allowing managers to focus and take actions on these areas. For instance, Chrysler Corporation, for example, estimates that since 1991, ABC has helped to provide hundreds of millions of dollars in benefits. These benefits include the simplification of product designs and the elimination of unproductive or redundant activities [13]. Consequently, ABC activities have been adopted by many companies in a variety of sectors and have brought about essential changes in cost management system. The principles and philosophies of activity-based thinking apply equally across all sectors, not only manufacturing industries but also service industries and government agencies. For instance: Healthspan Transportation Service in...
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