Disadvantages of ABC Costing

Disadvantages of ABC Costing

Disadvantages of activity based costing may be explained in terms of complexity, cost driver identification & selection, all cost coverage, and number of activities;

1.    Complex System

First disadvantage of ABC costing is its complexity. Activity based costing is a complex system of identification of activities and cost drivers and require extensive business experience and deep understanding of the business.

2.     Cost Driver Identification & Selection

Activity based costing implementation requires technical knowledge and extensive business experience. A number of factors are to be considered while deciding the appropriate cost driver. There may be more than cost driver for single activity, which may further complicate the selection of cost driver.

3.    Extension of absorption costing

Activity bases costing are just a complex extension of absorption costing and basic technique of absorption rate is still applicable in the activity based costing. There is more than one absorption rate in activity based costing as compared to single absorption rate in absorption costing.

4.    All Costs Coverage

In activity based costing, Identification of activities to cover all cost is difficult process. There are number of single costs in the organization. For example factory rent, and therefore identification & selection of activities of all those single costs are neither practical nor rational.

5.    Activities Number

In activity based costing, how many activities will cover the cost is difficult task. Too many activities will complex the absorption process, while too little number will not cover all the cost. A lot of experience and working is required to determine the exact number of activities.

Advantages of ABC Costing

Advantages of ABC Costing

Advantages of activity based costing can be explained in terms of improved business knowledge, identification of key areas, and fair allocation of overhead, accurate product costing.

1.    Depth knowledge of business

Activity based costing provides detail knowledge of different types of activities in the organization and their contribution to a core cause of the organization i.e. profit maximization. The depth knowledge about activities and their role improves management overall understanding about business.

2.    Identification of Key Business Areas

Second advantage of activity based costing is its identification of key areas of the organization. This provides management useful information for controlling & planning. If management wants to control cost, it must focus on the areas responsible for major cost.

3.    Fair Allocation of Cost

Third advantage of activity based costing is fair allocation of cost.ABC costing is based on more fair allocation of resources especially in case of product cost. This vary reason that it activity based costing is preferred over absorption costing, which offers very general absorption methodology.

4.    Accurate Product Costing

ABC costing is more realistic allocate the absorption cost to the product. Each product is charged with the cost with level of activity used for its production. It is helpful to determine the accurate cost of a product

Conditions for ABC Costing

Conditions for ABC Costing

1.    Valuation at Full Cost

Activity based costing may be an option, when inventory is to be valued at full cost. Only activity based costing and absorption costing can be used for such stock valuation (full product cost valuation).

2.    Product Differ

Activity based costing is suitable, where product substantially differ from each other. This methods is also preferred, when product are produced as per customer specification. It is appropriate that different product is charged overhead on the bases of resource utilization.

3.    Low Labour Cost

Activity based costing is preferred for products, which have lower labour cost as compared to overhead costs.

4.    Production Value Differ Substantially

Activity based costing is also preferred for businesses, where production volume of different goods differ substantially, therefore activity based costing can be used for more appropriate absorption.

ABC Activities Identification

ABC Activities Identification

1.    Activities Generate cost

All activities which are responsible for creating or generating cost are identified. These activities include production process, material handling, etc. it is important that all major cost generating activity are identified, otherwise, this costing will not work.

2.    Production is key area

It is important to remember that production will remain the key area for identifying the activities. Many activities would be relating to production. However, some activities may fall outside the production area.

3.     Number of activities

A reasonable number of activities will be identified to cover all the cost. What is the reasonable number, it depends on the nature of business. General criteria are to identify all major activities which are responsible for major costs.

4.    Too many activities are complex

Identifying too many activities will make the absorption process complex and time consuming. It would be difficult to use too many cost centers for accumulation of cost and then absorption of such accumulated costs.

5.    Too little activities will not cover the cost

Identifying too little activities will not cover the cost and therefore purpose will not be served. Business knowledge and experience of the business and industry is key factor for deciding right number of activities

ABC Costing Process

ABC Costing Process

ABC is a costing method, in which costs may be allocated on the bases of different activities which are responsible for that cost. This activity not necessarily required to be a production activity.

1.    Identification of activities

First step of activity based costing is to identify the all activities which generate cost. This is a complex process and requires a lot of business knowledge and experience.

2.    Allocate Cost to activities

Second step of activity based costing is to allocate cost to identified activities. It means every identified activity is a cost pool or cost center. All cost related to that activity (cost center) is accumulated.

3.    Different Absorption Rate

Third step is to calculate separate absorption rate for each activity. These rates are used to charge cost of activities to the production. Charging criteria is level of activity utilized by the production or other department

ABC Costing Assumptions

ABC Costing Assumptions

ABC costing assumption may be explained in terms of change cost structure, large overheads cost, many new costs.

1.    Change of Cost Structure

ABC costing first assumption is change in cost structure of modern organizations.      The cost structure of organizations has changed. Typical cost structure main element i.e. direct labor does not form a major product costs any more.

2.    Large Overhead Cost

ABC costing second assumption is large overheads cost in modern organizations. In new cost structure, overheads cost are more than direct cost (labour & material).

3.    Many New Costs Emerged

ABC costing third assumption is emergence of new costs in production processes. Many of these costs do not relate to production activities like quality assurance cost or material handling cost. Therefore it is not appropriate to absorb these costs using production absorption rate.

4.    Old Absorption method is not representative

Old Absorbing method of overheads allocation may not be representative of actual cost incurred in the change scenario. There is need of more accurate allocation of cost. Therefore new absorption methods are required.