Activity based costing (ABC) is a cost accounting approach concerned with matching costs with activities (called cost drivers) that cause those costs. It is more sophisticated kind of absorption- costing and replaces labour based costing system. ABC states that (1) products consume activities, (2) it is the activities (and not the products), that consume resources, (3) activities are the costs drivers, and (4) that activities are not necessarily based on the volume of production. Instead of allocating costs to cost centres ( such as manufacturing, marketing, finance), ABC allocates direct and indirect costs to activities such as processing an order, attending to a customer complaint, or setting up a machine. A subset of activity based management (ABM), it enables management to better understand (A) how and where the firm makes a profit, (B) indicates where money is being spent and (C) which areas have the greatest potential for cost reduction.
The motivation to choose the ABC system is because it is too difficult to assign some cost like, indirect cost, management salaries and office staff salaries through Absorption costing. And this method (ABC) has found its niche in the manufacturing sector.
It can be applied to derive realistic costs in a complex business environment. It can be applied to all overhead costs, not just production overhead and also it can be used just as easily in service costing as in product costing.
Although it is apparent that ABC alleviates considerably many of the worst effects if the arbitrary product line cost allocations inherent in many conventional systems, it does not eliminate the mall.
Cost pool: some measure of cost apportionment may still be required at the stage of cost pooling. Overheads common to more than one cost pool (especially in the absence of specific resource metering) could include rent rates, insurance, building deprecation, power, heat, and light. They may require to be attached to cost pools although no definition means of doing this is available. Indeed the proliferation of cost pools under an ABC system could increase the amount of such apportionment which is necessary.
Cost drivers: once pooled an appropriate cost driver must be used to attach cost to individual products. It is doubtful whether even a very detailed segmentation of cost into a large number of cost pools will ever achieve a perfect homogeneity within each pool. Thus the ability of a single cost driver to fully explain the cost behaviour of a cost pool is questionable.
In order to have a usable cost driver a cost must be caused by an activity that is measurable in quantitative terms and which in turn can be related through this measure to production output. Not all costs will be readily susceptible to this process.
For example, it will be difficult to identify meaningful cost drivers for corporate as opposed to based advertising, top managerial activity relating to the business as a whole and other general costs such as external audit, finance costs and goodwill amortisation.
It is doubtful that ABC system can completely avoid the problem of cost commonality at the stage of applying cost driver rates to achieve product line costs. This will occur where the chosen cost driver relates t more than one product. For example where a maintenance hour is spent in repairing a facility used by several products or a purchases order contains items used on many different products. The cost of that hour or invoice is not specific to one product but will have to be spread over all products affected on the basis of the cost driver weightings given to each of the relevant products. The selection of cost driver is not automatically provided mangers with an easy-to-step cost control ‘handle’. (ABC book, p.109). Also this ABC system is not good for making decision because this is not true...