Activity Based Costing System
To efficiently administer the various functional areas and activities for which the manager is responsible and also to co ordinate these functions and activities within the overall framework of an organization is the two major purpose of an accounting system.(Horngren et al. p 2) Especially the management accounting systems contemplate to analytically measure and report all financial and non-financial information so that the managers can make fruitful and effective decisions to fulfill the goals of an organisation. Thus the focus of the management accounting is mainly internal reporting of the various activities. Modern day management accounting plays a very significant role in both planning and control decisions. Hence in the process of decision making the management accountant has to make a number of realistic and logical assumptions in arriving at an optimal solution for the problem on hand. For enabling the management accountant to take a stand on the various assumptions in the process of decision making, the cost of the product or service is a key element. Traditionally there are various methods of ascertaining the cost of a particular product or service. One of such methods is collecting the various cost elements and allocating them to the particular product or service which is known as unit costing. The other method by which traditionally the costs were determined is standard costing.
Standard Costing – An Ineffective Tool under Certain Circumstances:
As outlined above one of the traditional ways of ascertaining the cost is to apportion a standard cost for each unit based on historical cost data. Investorwords.com defines Standard Costing as “A management tool used to estimate the overall cost of production, assuming normal operations.” This system of ascertaining costs and base the managerial decisions has lost significance due to the fact that modern companies tend to have lower truly variable costs as against a very high degree of fixed costs. Also the equipments that are being used have become more complex and specialized and they form a very significant proportion of total costs. In addition organization with a wide range of products has processes which are common to several finished items making cost allocation irrelevant or meaningless.
Alternative to Traditional Costing Systems – Activity Based Costing System:
An alternative to the traditional costing systems, modern day multi process business corporations adopt the activity based costing system which has proved a real tool in the hands of the managers for making proper business decisions. (Horegren et al. p140) The activity based costing system is a refinement of the costing system in which focus is centered on the individual activities as the fundamental cost objectives. An activity in an organization may take the form of an event, task or unit of work with a specified purpose. To illustrate; the design activity, set up activity, manufacturing operations, shipping activity, distribution activity and administrative activity can form the basic key costing elements for the refinement of the costing system and thereby to arrive at the proper cost of a particular unit or service.
ABC system aims at calculating the costs of the individual activities and assign costs to cost objects such as products or services on the basis of the activities undertaken to produce each product or service.
Features of ABC System of Costing:
Fundamentally there are three distinct features of the activity based costing system:
1. ABC system works by creating smaller cost pools linked to different activities. Traditionally organizations used to have single overhead cost pool related to several cost pools.
2. For each activity-cost pool ABC system aims to measure the activity performed
and have this as the base.
3. In some cases costs in a cost pool can be identified and traced back to a particular
Product or department or service and such kind of direct tracing of costs improve
the cost accuracy as no assumptions is made to allocate the common costs.
“Activity-Based Costing encourages managers to identify which activities are value-added—those that will best accomplish a mission, deliver a service, or meet a customer demand. It improves operational efficiency and enhances decision-making through better, more meaningful cost information” (OSD Comptroller iCenter).
Limitations of Activity Based Costing System:
Although there are significant merits in using the ABC system, the system is not left with some serious limitations which make the companies to rethink about introducing this costing system. The principal limitations are:
More Detailed Analysis:
The main costs and limitation of ABC system are the details and measurements necessary for implementing the system. Even a simple ABC system requires the management to identify different cost pools or activities and allocate the total indirect costs to those defined activity. These measurements are expensive and prove costly to the management. The activity cost rates are to be reviewed very often and updated. This involves lot of detailed working and costs. Very detailed ABC systems are costly to operate and difficult to understand.
Possibility of Errors:
When the activity based cost pools are to be determined and costs are allocated to those bases there are possibilities that errors may occur in measuring the activities. Such errors may vitiate the very purpose of the detailed costing system and will end in wrong decisions being made on the basis of erroneous cost allocations. When measurement errors are large, activity cost information may be misleading.
Complex Allocation Process:
With a detailed working of the activity based cost pools, often it becomes difficult to maintain a simple approach to the costing data and information. During such times, the companies are forced to use substitute allocation bases for which data are readily available rather than the preferred allocation bases. It may also result in the operation staff to have significant disagreements with the accounting staff about the costs of manufacturing and marketing products and services.
Despite the limitations the ABC system of costing is gaining prominence in manufacturing industries which involve more departmentalized production processes.
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