Activity Based Costing Essay

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Activity-based costing (ABC) employs numerous cost groups, organized by activity, in the allocation of overhead costs. The conception is that activities are necessitated to generate products, basically activities, such as procuring materials, setting up machinery, assembling products, and scrutinizing finished products. It is imperative to note that these activities can be expenses and therefore the cost of activities ought to be apportioned to products on the basis of how the products use the activities. The costs are placed on the products on the basis of the use of individual products for every activity (Hansen et al., 2007). In the traditional product costing system, to begin with, costs are not linked or mapped out to activities but they are rather traced to a unit within the organization, for instance a department or a division, and thereafter to products. This implies that in the traditional and ABC costing systems, the second as well as finishing stages are made up of linking costs to the product. Nonetheless, by laying emphasis on activities, the activity-based costing system attempts to determine the factors that cause every key activity, cost of these sorts of activities and the association between activities and the products produced (Lal, 2009). The purpose of this paper is to discuss the theoretic shortcomings of activity-based costing and the decision encompassed on the manner in which cost drivers are chosen for an activity.

Theoretical Weaknesses of Activity-Based Costing

Without doubt, activity-based costing provides better cost information in comparison to majority of traditional approaches of costing, for instance department and plant wide allocation approaches. Nonetheless, ABC does have its weaknesses and shortcomings. To begin with, activity-based costing systems can be costly and expensive to carry out. In particular, ABC systems necessitate collaboration and coordination across the organization, and as a result necessitate personnel to take breaks and time off from their everyday activities to provide assistance in the ABC process. In addition, apportioning activities takes time and so does the ascertaining and tracking of cost drivers. Moreover, apportioning cost to the firm products necessitates a substantial amount of time within its accounting division (Heisinger, 2009).

A second weakness of the ABC system is the aspect that its centralizing of fixed costs is deceptive and distorted. Product costing takes into account apportioning costs from activity centers to products and computing product cost per unit. The weakness and shortcoming to this method is that fixed costs are more often than not a major part of the overhead costs being apportioned. Examples of some of these fixed costs include salaries and depreciation for buildings and machinery. It is imperative to note that fixed costs are the outlays that remain constant in total with changes in activity. For instance, in using activity-based costing assume that a company incurs $10,000 per unit to produce 2,000 units. In the event that the firm produces 4,000 units, the unit cost is not expected to remain constant at $10,000. Imperatively a substantial percentage of overhead expenses are fixed and as a result will be spread out over the increased number of units, which will cause a decline in the cost per unit. Therefore, the shortcoming of the ABC system is that it will offer misleading information regarding decision making, especially if the form expected a significant change in the level of production (Heisinger, 2009).

In accordance to Bendrey et al. (2003), another theoretical flaw of activity-based costing is the necessity of more detailed analysis. In comparison to the absorption costing approach, the ABC approach necessitate a more comprehensive analysis of cost drivers and cost pools, with a resultant increase in the cost of running the accounting system.
Moreover the approach requires additional simplification. In particular, the aspect of ascertaining cost pools and cost drivers is not always an easy and direct undertaking. At times, it is essential to vindicate and give a good reason for the number of cost pools and cost drivers aimed at diminishing the intricacy and cost of the activity-based costing system. This may be considered to be a weakness to the ABC system. Moreover Bendrey et al. (2003) indicate that the ABC system has a weakness in the lack of conformity to SSAP 9. In particular, the ABC system reassures all costs, comprising selling and distribution costs. This aspect encompasses and spreads across the standard foundation for prizing stocks for financial accounting reasons. SSAP 9 necessitates stocks as well as work in progress to be valued at complete production costs up to the phase of finalizing the end-product, which would generally disregard retailing and distribution expenses (Bendrey et al., 2003).

Another theoretical demerit of the activity-based costing system is that the approach has dissimilar levels of utility for dissimilar entities, for instance major manufacturing companies can employ it more efficaciously in comparison to smaller companies. In addition, there is a likelihood that companies that rely on cost-plus pricing can make the most of ABC method, owing to the fact that it provides precise and correct product cost. However, the companies that employ market-based prices may not have a preference for ABC method. The level and magnitude of technology and manufacturing setting existing in various companies also have an influence on the application and administration of ABC systems (Lal, 2009). Another major weaknesses of the ABC method is that its execution is largely costly. To begin with, setting up the system can be costly and time-consuming. With the analysist of activities for an organization, such activities must be further itemized into the individual constituents of every activity. The process, as a whole, can come to an end and deplete valuable resources as data is gathered, measured, and keyed into the new system. In addition, organizations may also need the help of a consultant that is an expert in setting up an ABC system and can offer training on its application and administration. The utilization of software can bring into play an extra expense for the execution and computerization of the manual elements that encompass using the activity-based costing system (Lal, 2009).

The ABC system is also considered to have a flaw as it misconstrues data. The information reported by an activity-based system takes into account data, for instance, product margins, which are completely dissimilar from the information that is produced by a traditional costing approach. Moreover, it is conceivable that a number of costs entailed in the ABC system may be immaterial and unrelated in particular decision-making instances. A very fitting illustration encompasses the sense that ABC does not comply with standards and, for that reason, cannot be employed by companies for the purposes of external reporting. Taking into consideration that traditional cost amounts and figures have a tendency of being the standard figures, construing and understanding data from the ABC system together with common accounting information can be perplexing, giving rise to an organization making poor decisions (Weygandt et al., 2009).

Decision on how Cost Drivers have been chosen for an Activity

Execution of the ABC system is a cost assignment practice that consists of two phases. The first phase is the tracing of direct….....

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Bendrey, M., Hussey, R., & West, C. (2003). Essentials of management accounting in business. Cengage Learning EMEA.

Cokins, G., &Capusneanu, S. (2010). Cost drivers. Evolution and benefits. Theoretical and Applied Economics, 8(8), 7.

Gill, S. (2015). Cost and Management Accounting: Fundamentals and its Applications. India: Vikas Publishing House.

Hansen, D., Mowen, M., & Guan, L. (2007). Cost management: accounting and control. Cengage Learning.

Heisinger, K. (2009). Essentials of Managerial Accounting. Ohio: Cengage Learning.

Lal, J. (2009). Cost Accounting 4E. Tata McGraw-Hill Education.

Way, J. (2017). How to Determine Cost Drivers. Chron. Retrieved from:

Weygandt, J. J., Kimmel, P. D., & Kieso, D. E. (2009). Managerial accounting: tools for business decision making. John Wiley & Sons.

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