Activity based Costing, Inadequacies of conventional Costing Systems

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Activity based costing is the collection of operational and financial performance information tracing the significant activities of the firm to produce costs.

Inadequacies of conventional Costing Systems:

Traditional costing systems have certain adequacies that are here as under:

a) When valuing stocks for financial reporting, traditional costing system has made it acceptable to develop convenient overhead recovery basis and blanket overhead recovery, but these give inappropriate results when used for decision making and typical product strategy decisions. These decisions have long term implications.

b) When making direct labor component to small proportion, cost structure is changing.

c) Companies that are engaged in a business of manufacturing and selling multiple products usually make decisions on distorted cost information due to traditional costing system difficulties.

d) The traditional fixed versus variable cost split is often unrealistic since, they become more complex as business grow.

e) Traditional costing system provides information at product level. When new manufacturing technology is being employed, it requires feedback while production is in process.


ABC concept is basically designed to get more accurate product cost by redesigning the allocation system of respective overheads like tooling, production planning stup etc. ABC uses a more realistic approach to absorb overheads into product costs in cost accounting. Many supporters of ABC system believe that many costs are treated as common costs; they must be absorbed using appropriate basis i.e. labor hours, machine hours. The basic idea behind ABC concept is that costs are being classified according to what drives them i.e. their drivers.

Objectives of ABC:

Here is the list of some of the objectives of this system:

a) To improve the accuracy of product costs by careful monitoring of type changing and basis used to assign costs.

b) To use the information obtained to improve product mix and pricing decisions.

c) To identify value-added activities in transactions.

d) To point out ways to remove non value-added activities.

e) To attach costs in response to price resistance had given but customers.

f) To allocate overheads on the basis of activities.

g) To validate the success of quality drive with ABC.

h) To provide accurate product costing for decision making process.

i) To focus the high cost activities.

j) To ensure high quality information about product, activities and customer non-manufacturing activities.

k) To identify the opportunities for profitably shifting the focus toward more profitable products, services and customers.

Steps in Implementing ABC Costing System:

In order to implement ABC costing system, it would involve multiple steps:

a) Process Specification:

The initial step involves identification of the production process, the assurance of resources to each processing time and bottlenecks at different stages. This step would result into a list of different transactions that would result into activities at subsequent steps.

b) Identify Main Activities:

Next step is to identify the main activities prevailing in the industry. Consolidation of multiple activities in known as activity. These activities are further classified into primary and support activities.

c) Identify Non-value Added Activities:

In industry, there are multiple those activities that do not add any value to the product, so in this step all those non value added activities are being recognized for elimination.

d) Identification of Activity Cost Pools:

In this step, costs are being classified on the basis of driver’s e.g. a cost pool may be of procurement of goods, in this case all costs that are associated with it like ordering, inspection, storing etc are involved in this cost pool.

e) Selection of Activity Cost Pools:

In this step, the main focus is to identify the factors that determine the costs of an activity that are known as cost drivers. These are used to trace costs to products by using a measure of resources consumed by each activity.

f) Tracing of Cost with Cost Objects:

This is the final step at which costs are traced. The cost objects are linked to the objective of the organization. Cost object means reason for performing an activity.

g) Staff Training and Reviews:

After the implementation of ABC system , staff is being trained so that they got enough control over this system. Periodic review and follow up action is necessary for successful implementation of system.

Advantages and Disadvantages of ABC:

By using ABC costing system, it becomes possible for many industries to ascertain most accurate product costs. It helps in ascertainment of product costs based on both financial and non-financial information. It recognizes the cost behavior and identifies value and non-value added activities. Management information system is strengthened with better and accurate information.

ABC system does have some disadvantages as it is a complex system, which consists of various cost pools and cost driver rates. It is also difficult to attribute costs to single activities. It requires total commitment from top level management. Substantial amount of money and time is also required.