The Disadvantages & Advantages of Activity-Based Costing Chron com

Advantages and Demerits of Activity Based Costing

ABC highlights non-remunerative distribution channels allowing the management to adopt alternative marketing strategies or close down the channel for a more profitable one. Eliminating the cost of maintaining or running non-remunerative activities, increasing overall profitability. Eliminating unprofitable items from the product line, thereby increasing profitability without increasing prices, a valuable option in recessionary times. Review resources consistently and make necessary adjustments to ensure your cost information remains current over time. Break down activities as much as possible to ensure accuracy in allocating costs. Too much emphasis on customer viability can lead to problems such as cheaper products and, therefore, potentially lower sales.

Advantages and Demerits of Activity Based Costing

Costs tracing, accurate allocation of costs to various products lead to proper pricing policy. Also, Cost driver rates can use advantageously for the design of new products or existing products as they indicate overhead costs that are likely to apply in costing the product. Activity Based Costing is a 2 step method of costing whereby costs are first allocated to ‘identified activities’ of a business and then from activities they are assigned to products or services. In other words, the costing of products or services is based on activities performed to manufacture/render a particular product or service. If, for manufacturing a product A, activity X is not used, the cost for that activity would not be allocated to that product A.

Production facility cost

Examples of facility level activities are factory management, maintenance, security, plant depreciation. In Activity Based Costing system, facility level activities and costs are treated as period costs as they are found difficult to assign to different products. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold. ABC is designed to track the cost of activities, so you can use it to see if activity costs are in line with industry standards.

What are disadvantages of activity-based costing?

Disadvantages of ABC:

It is impossible to allocate all overhead costs to specific activities. The choice of both activities and cost drivers might be inappropriate. ABC can be more complex to explain to the stakeholders of the costing exercise. The benefits obtained from ABC might not justify the costs.

Before making any significant decision using activity based costing data, managers must identify which costs are really relevant for the decisions at hand. The allocation bases (i.e., measures of activity) often differ from those used in traditional allocation.

Advantages and Disadvantages of Activity Based Costing (ABC)

ABC enables effective challenge of operating costs to find better ways of allocating and eliminating overheads. It also enables improved product Advantages and Demerits of Activity Based Costing and customer profitability analysis. It supports performance management techniques such as continuous improvement and scorecards.

This can be possible by getting into contact with workers throughout the organization most difficult thing here is summarizing various activities related to those with the biggest impact on overhead cost. They can use by any organization that wants a better understanding of the costs of the goods and services it provides, including manufacturing, service, and even non- profit organizations. The next step of Activity Based Costing process flow involves identifying the costs that the organization wants to allocate. This step will help to save time later on as no one wants to waste time unnecessarily on specifics that are not relevant at that particular time. The first step of Activity Based Costing is to identify the critical activities involved in the production process through activity analysis. Over and under costing was a result of such a method of averaging and loosely defined cause and effect relation between the cost and the product.

4 Comparing Traditional & Activity-based Costing

Service organizations, such as banks, hospitals and government departments, have very different characteristics than manufacturing firms. Service organizations have almost no direct costs, most of the costs are overheads and they do not hold stocks of service as the service is consumed when it is produced. Traditional costing has generally been considered inappropriate for these organizations, whereas ABC offers the potential of benefits from improved decision making and cost management. ABC produces more accurate costing of products by essentially converting broad indirect costs into direct costs of production. It determines the costs of the various sources of indirect costs and allocates these expenses to the specific activities that use them.

  • This costing system is used in service pricing, customer profitability analysis, product line profitability analysis, product costing, and target costing.
  • You might incur extra costs in the time and labour it takes to collect and analyze the information needed for this model.
  • These levels include batch-level activity, unit-level activity, customer-level activity, organization-sustaining activity, and product-level activity.
  • Activity Based Costing is an accounting method used to identify and assign costs to products, services, and activities.

Data concerning numerous activity measures must be collected , checked and entered into the system. Traditional costing systems are driven by the need to value stocks rather than to provide meaningful product cost. Activity Based Costing is cost attribution to cost units on the basis of benefits received from indirect activities i.e., ordering, setting-up, assuring quality etc. The aim is to comprehend the various activities needed to manufacture the company’s products.

What is Activity Based Costing?

The ABC system assigns costs to each activity that goes into production. It is a costing method that identifies activities in an organization and assigns the cost of each activity to all products and services according to the actual consumption by each. Activity-based costing benefits the costing process by expanding the number of cost pools that can be used to analyze overhead costs and by making indirect costs traceable to certain activities. These activity based costing advantages and disadvantages show that this costing method can be beneficial for the complex modern production models that exist today.

  • The products which are victims of over costing automatically allow another product’s under costing and vice versa.
  • This is possible since behaviour of many fixed overhead costs in relation to activities now become more visible and clear.
  • Standardisation was not a common notion in Chinese culture or in place in many Chinese companies.
  • Develop criteria for allocating costs that takes into account each product or service’s contribution to overall profits.
  • How do managers determine what the standard cost should be?

Activity based costing data can be easily misinterpreted and must be used with care when used in making decisions. Costs assigned to products, customers and other cost objects are only potentially relevant.

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