Activity-Based Costing

In the previous chapter you learned about job costing, and this chapter presented process costing. You may be wondering why there could possibly be a need for yet another approach to determining how much a product costs to produce. Nevertheless, in recent times a number of companies have expressed frustration with the traditional methods. This has led to an increased utilization of a uniquely different approach called activity-based costing (ABC). A simplified explanation of ABC is that it attempts to divide production into its core activities, define the costs for those activities, and then allocate those costs to products based on how much of a particular activity is needed to produce a product. Before digging into the details, it is best to first consider the pros and cons of ABC.

Pros of ABC

Traditional costing methods divide costs into product costs and period costs. The period costs include selling, general, and administrative items and are charged against income in the period incurred. Product costs are the familiar direct materials, direct labor, and factory overhead. You know how these costs are traced/allocated to production under both job and process costing techniques. However, some managers reject this methodology as conceptually flawed. For example, it can be argued that the cost of a finished product should include not only the cost of direct materials, but also a portion of the administrative cost necessary to buy the raw materials (e.g., many companies have a separate administrative unit in charge of all purchasing activity, like writing specifications, obtaining bids, issuing purchase orders, and so forth). Conversely, the cost of a plant security guard is part of factory overhead, but some managers fail to see a correlation between that activity and a finished product; after all, the guard will be needed no matter how many units are produced.

Activity-based costing attempts to overcome the perceived deficiencies in traditional costing methods by more closely aligning activities with products. This requires abandoning the traditional division between product and period costs, instead seeking to find a more direct linkage between activities, costs, and products. This means that products will be charged with the costs of manufacturing and nonmanufacturing activities. It also means that some manufacturing costs will not be attached to products. This is quite a departure from traditional thought.

Another benefit of ABC is that a product is only charged with the cost of capacity utilized. Idle capacity is isolated and not charged to a product or service. Under traditional approaches, some idle capacity may be incorporated into the overhead allocation rates, thereby potentially distorting the cost of specific output. This may limit the ability of managers to truly understand and identify the best business decisions about product pricing and targeted production levels. This problem was touched on in the previous chapter's discussion of capacity utilization.

Cons of ABC

One limitation of ABC is that external reporting must be based on traditional absorption costing methods. Absorption costing requires the traditional division between product costs and period costs, with inventory absorbing all of the manufacturing costs and none of the period costs. As a result, ABC may produce results that differ from those required under generally accepted accounting principles (GAAP). Therefore, ABC is usually viewed as supplemental in nature. It is used for internal management decision making, but it may not be suitable for public reporting (note: when the aggregate financial statement results do not differ materially between ABC and other methods, ABC can be used for both internal and external purposes).

The fact that ABC is not GAAP usually means that a company that wishes to benefit from ABC must develop two costing systems - one for external reporting and one for internal management. Some companies feel they have enough to do without working through two costing methods! Another disadvantage of ABC is that it is usually more involved than other approaches. Rather than applying all factories overhead on some simple basis such as labor hours, it requires the development of numerous cost pools that must be individually allocated. In other words, ABC is a more intensive technique, and the costs to implement it may not be worth the trouble.