Activity Based Costing

1. Activity Based Costing • Absorption costing often misstates product costs. The reason is the simplicity of the basic cost allocation process which is based on some simple measure such as direct material or labor units or prices, or machine hours. ABC tries to explore cost behavior more closely in order to develop more accurate product costs. • The first step is to identify key activities that serve as cost drivers.

2. Activity Based Costing • ABC views product costs as results of activities. Each product/service/process in the firm is thought in terms of the bundle of activities required to produce/provide/run the product/service/process. • For instance, making a batch of spares requires material & labor (costs that vary with batch size), accepting the order and scheduling it, ordering the materials, setting up machines (all costs that do not vary with batch size), a sales catalog (costs that depend on the firm’s lines of business) etc ..

3. Activity Based Costing • ABC cost systems are complex beasts: they require a deep understanding of the organization and its processes. They are costly to develop and maintain. At the bottom they are fundamentally linear in approach … see the equation on p. 530. • Read carefully the example (pp.532-535).

4. Activity Based Costing • ABC highlights the costs of additional production complexity relative to traditional absorption cost systems: products that use more labor hours in this example tend to have higher costs under absorption costing. Under ABC, the costs of complexity are broken out, product line costs are traced directly to products so that less overhead is left to be spread out using labor hours.

5. Activity Based Costing • ABC improves understanding of cost flows – more costs are directly traced to products. • ABC is supposed to produce more accurate product or product-line costs – costs are more closely correlated to actual output. • However ABC poses the problem of how many cost drivers to use? • Smart managers can play games with drivers just as much as they could with the traditional overhead allocation bases.

6. Activity Based Costing • ABC does not handle joint costs any better than other cost methods. • ABC is no better adapted (than say absorption costing) for making strategic decisions such as being a full-line producer or making a loss-leader or carrying excess capacity in lean times. • ABC is not as useful in lean manufacturing environments where overhead activities are systematically eliminated so that direct costs increases to 80% or 90% of total costs. • ABC does help some types of businesses to better understand their activity flows.