Activity-Based Costing: Definition, Advantages, And Limitations

Introduction to Activity-Based Costing

Activity-based costing is a costing strategy used by business houses or industries to assign indirect costs to their products; or disburse their income or expenses to different business operations. The activities are often under the head direct costs; however, the allocations are made as a ration of the sales of the total sales. In this system of costing the total pool of cost are being allocated to different activities and then those activities are being allocated to the respective cost center as per their nature (Chron, 2017).

Then those costs are distributed based on the cost drivers. In this case, the cost driver is the percentage of the activity or allocation base which determines the total activity cost to be altered. There is a simultaneous relationship between the cost driver and total cost that is more of units of a cost driver, more will be the total costs. For instance, the cost driver for electricity expenses is the hours a machine operates during production. Following this costing principle, all of the costs can be divided into 3 groups; including semi-variable, variable and fixed. These costs may be allocated based on space used for storage cost. The total volume of material to allocate freight cost, machine hours, labor hours and effort required in the sale of the final product etc. According to Dan (1995) the approach is popular because it uses few resources in an effective and efficient way.

Merits of the ABC costing strategy

Advantages of the activity-based costing are given below:

1. It helps in determining the effective cost of manufacturing of given products. This is very critical for the pricing process as otherwise wrong costing will be done and some of the materials may end up in profits and some in losses thereby having no product wise profitability(Dichev, 2017).
2. It assisting in calculating the cost properly and accurately the cost of product and help in providing proper allocation amongst different products. This is again important as ABC costing as well as Time Driven Activity-based costing gives a way out for allocation. It generally gives a standard key which can be used for allocation purposes.
3. It also highlights what are inefficient segments and helps in reducing the wastage of money. The inefficient processes, as well as products and segments, can be eliminated from the company as there are many alternatives one of which is the outsourcing of the processes.
4. It also provides a more absolute way to calculate profit margin so that the manufacturing overhead can be reduced to a relatively low level(Alexander, 2016).
5. Demerits of the ABC costing approach

Apart from all these advantages the approach also endures from many limitations as well. Which are given below: 

1. It is a time-consuming process which takes lots of time which require the lot of effort to collect and analyze the data(Belton, 2017).
2. It may not be the healthy approach for a small company as it is an expensive process. This is because the use of time driven activity-based costing, as well as the traditional activity-based costing, can only be realized when the base is higher and the company is big selling a number of products.
3. As the ABC costing technique is not following generally accepted accounting principles because of that, ABC report is used for external reporting purposes. There is a separate costing report which needs to be prepared for reporting purposes thus adding to the total efforts(Fay & Negangard, 2017).
4. The result taken from the ABC technique may vary from that obtained from traditional costing methods – this creates conflict.
5. For the proper utilization of ABC costing technique in-depth knowledge of the organization, its operation and nature are required. Additionally, the allocation; costing; cost drivers; cause and effect relationship; and allocation are required.
6. Evaluation of the Journal Articles

In this section we analyzed two journals, including “The Measurement and Management of Unused Capacity in a Time Driven Activity Based Costing System” by Veyis Naci Tanis and Hasan Özyapici;  and “The Value of Activity-Based Costing in Competitive Pricing Decisions” by Warlop Luk, Eddy Cardinals; and Filip Roodhooft (Eddy, Filip, R, & Warlop, 2004).

Discussion of the Selected Topic

From the first journal, we analyzed the features of the activity-based costing (ABC) which allow effective determination of prices, especially in the manufacturing industry. From the in-depth study of this system one thing clear that the ABC costing system is more beneficial than volume-based costing for cost allocation process. According to Gooley (2016), the ABC approach allows companies to reject irrelevant competitor feedback:  this promotes efficient decision-making.

Aims of the Study and Research Questions

The purpose of study this system of costing is to evaluate the importance of this approach in decision making when complete information considering all the factors are not available with the accountant for effective price calculation. In recent days it is very difficult to fix price based on existing market condition. In such a situation market plays a negligible role as the price of the product completely depend upon market feedback which generally supersedes the accounting information. Raiborn, Butler, and Martin (2016) explain that based on the multimarket price fixation technique, the traditional costing methods provide mispriced cost estimates; the prices are either overallocated or under allocated or suffer a high loss in a certain market segment.

Merits of the ABC Costing Strategy

In some cases, the market affected by biased costing method provides a cost data which shows good pricing (Briers et al. 1999). However later on with the help of two hypotheses, the test was conducted to evaluate the result in real terms. Now, the significant question is what were the two hypotheses? The 1^st theory explained that profits and prices are optimal when the company receives positive reviews from the customers. The second hypothesis suggests that the market feedback is more informative when the ABC technique fails, due to the biased cost data. To determine the effect clearly, an experiment was conducted.

The study involved two groups consisting of 131 cost accounting and management accounting students. The participants were given price information and requested to determine the cost using the two costing technique: the traditional costing method and the ABC costing approach (Bromwich & Scapens, 2016). For the ABC system, the cost allocated depends on three activities, including delivering, ordering and software handling. However, the cost of activity depends on the ABC approach in two market segments and their cost-driver. Examples include the deliveries, software handling and the number of orders (Goldmann, 2016).

Then the result of these was examined to see the impact on the profit over ten different periods and judge the stability of the process. The method was taking an average of the 1^st five results to review the interaction between the market feedback and the accounting report which were found less relevant on examination of data. The study indicates that the second hypothesis is wrong.

Therefore, the competitors either operate in places where information is not detailed; or in competitive markets. Notably, if the firm accurately allocates cost activities, after considering the suitable host driver, then it provides the most relevant cost for the product. In this way, the company makes the product more competitive; and creates an efficient cost fixation process.

The primary question that this article answer is how to estimate the unutilized capacity in a firm using the biased costing system for the second case study. In some cases where the companies working and functioning whole day whole night then it might be difficult to determine what is the unused capacities. Choy (2018) argues that companies must evaluate two compulsory and real unused capacities. The main goal of this study is to enhance the effectiveness of the TDABC and ABC technique by the describing the unused capacities per shift.

The ultimate goal here was to redistribute employees to other more productive areas depending on the per shift, rather than the unused capacity. However, it is not possible through the traditional method of costing because one a days it becomes less effective and overall basis on which it works as become useless. In the today’s competitive environment the companies were looking for more advanced and cost-efficient method of costing that can help them in cost management. However, one of the major constraints of ABC costing system selection of the cost drivers for the allocation of the costing element under different cost segments and optimum utilization of resources of the company is had underlined with the help of this case study.

Limitations of the ABC Costing Strategy

The contemporary tool of the ABC approach is time driven and must be deployed to improve the company’s competitive advantage. Under this system of costing the first thing manager need to understand the what is the resource and what is the optimum quantity of resources required to complete the activity effectively and efficiently (Visinescu, Jones, & Sidorova, 2017). Implementation of the TDABC involves two aspects; one is the cost per unit of resources, and the other is the number of products used by the services, activities, and clients.

The main focus to this system of costing is eliminated all the limitation imposed by the activity-based costing and improve the productivity of goods and try to incorporate all those features which get ignored under the ABC system. In general terms, it helps in calculating the time and resource required to complete the activity. In this system, the cost is calculated on the basis of practical capacity in place of the cost per unit (Naci & Hasan, 2012). Like a machine actually works for 50 hours a week as per details but if we calculate effective hours we can consider almost 80-85% of total hours which accounting to approx. 40 hours per week.

The major area of focus is here is that to take into account the practical and effective capacity otherwise the cost allocation, as well as the full results, would not be accurate. However, the other criteria are the calculation of a number of unit of the resource being used and to calculate the number of the units the manager can use these tactics like interview their employee or do estimates through direct observation procedures. Some entities follow this principle with their employee it might be not the exact result but provide a rough estimate.

Similarities and Differences

There are a few similarities between the 2 studies which are enlisted below:

1. Both the costing method has been initiated for the better management of time and cost and to reduce the overall cost to make the product more competitive at the workplace. This is also initiated to help the accountants with better cost allocation methods and thereby making it easier for costing and pricing of the products(Grenier, 2017).
2. The aim of creating the two costing techniques is to make pricing easier; and to mitigate the failures of the traditional costing method. It also aims to overcome the initial inefficiencies and highlight the areas which need to be eliminated. This not only helped a number of companies in cutting down on costs but also on the man-hours.

There are several differences between the two case studies, including:

1. In the first technique, the focus has been on the cost driver however in case of second technique emphasis shifted to time management. The shortcoming which was posted in the activity based system was overcome by time-driven activity-based costing which only focused on 2 aspects namely the number of time units required to complete the procedure and what is the cost of individual time units, thus harmonizing and simplifying the process(Knechel & Salterio, 2016).
2. Activity-based costing was focused on to eliminate all those all those factors that are the reason of poor management of time and resources and allocate the cost under accurate cost driver so that we can find out the optimum cost. And in the case of Time-based costing the real focus is on reducing the time taken that was taken to calculate the cost or selection of appropriate cost deliver, and make the process more easy and understandable. In recent days more of the companies preferred TDABC system over the ABC system(Linden & Freeman, 2017). However, both systems of costing have their own merits and limitation which is discussed to reach a conclusion.

However, there are many another issue where improvement is required to get the better results like time management which is resolved with the help of TDABC system and in case of issue related to the selection of cost driver the issue is resolved with the help of activity-based costing. Hence from the above discussion, it is clear that both the system are more improved than the traditional method of costing.

Specific Results and Relevant Concepts

From the in-depth study and deep analysis of theses research paper one thing clear that both the approach are highly useful and will be useful for accurate management of cost and time. In other words, it helps in cost reduction and increases the profitability. Some of the primary findings from the first case study include:

1. The company’s price-demand effect highly affects the market; compared to the competitors cross pricing. In case other competitor charges the lower price of the product small competitor will be left the meet with lower demand(Heminway, 2017).
2. Here the industry which follows this approach in case any new entrants want to enter in the specific market segment then the new player must follow the rules and principle set by existing market player.
3. The cases where the traditional method of costing is used for price fixation are generally not used as this approach provide a wrong allocation of cost and give an inappropriate result which reflects less accounting profit than actual. It also affected the sales if the competitive price of the same product is lower in the market. However, when the industries start following the ABC system the cost determined by the company is optimum as the method applied for cost allocation were reasonable and reliable. Hence the sales of the product increase(Trieu, 2017).
4. From the study of this approach, it is also observed that the negative feedback regarding these approaches less impacted to the companies who were using ABC technique rather than the companies who were followed by volume based costing techniques.

Key findings from the second case study are enlisted below:

1. One of the major issues that are resolved by the TDABC system is selecting of the cost drivers. In this system of costing focus was to use the practical capacity of the machine as it also provides the same result that what would be the expected output.
2. This approach also helps in cost reduction because of which the product would become more attractive and cheaper at the workplace and capture a significant area of the market. It also helps the companies to plan better for the future. This was not possible either in traditional costing system or in the activity based system.

References

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