Advantages and Disadvantages of Activity Based Costing in Modern Accounting B Com Institute Leave a comment

The service sector benefits from ABC’s methods for accurate indirect cost allocation and its ability to optimize business processes, leading to enhanced pricing strategies and operational efficacy within service organizations. ABC is particularly useful for businesses with diverse products or services, or those with complex production processes. Companies in industries like manufacturing, healthcare, or retail, where a range of activities and products consume different levels of resources, can benefit from the detailed insights that ABC provides. Manufacturing companies have significantly benefited from ABC by gaining a clearer understanding of their production costs. One example is a leading automobile manufacturer that implemented ABC to identify inefficiencies in its production process.

• Additionally, some critics argue that ABC may not be suitable for all businesses, particularly those with more straightforward operations.
• This new perspective lays the groundwork for managerial decisions that prioritize efficiency and market competitiveness.
• For example, if an organization finds that a particular activity costs more than it should, it can look for ways to streamline or eliminate it.
• For instance, all costs related to material handling—including wages of material handlers, forklift maintenance, and warehouse utilities—would be grouped into a material handling cost pool.

In the production industry, Td-ABC has provided cost-and-profit enhancement opportunities by identifying unprofitable customer relationships, unprofitable processes, and influences in product design and portfolio products. Nevertheless, it can unlock the identity of higher-margin services and promote these services, offsetting losses incurred and enabling a sustainable practice—one that can continue to serve people in need. In traditional costing system, overhead costs are assumed to be influenced by only units produced. It means, in traditional costing system, cost of batch level, product level and facility level activities is fixed costs, i.e., costs of these do not change as production volume changes.

ABC’s Role in Pricing Strategy

For businesses with diverse product lines or complex processes, ABC can provide valuable insights that lead to improved performance and profitability. However, for those with simpler operations, the traditional costing methods may still be the most efficient and cost-effective solution. Cost drivers are the factors that create costs, such as machine setups or quality inspections, while cost pools are groupings of individual costs related to specific activities. In the ABC methodology, the cost driver rate is calculated by relating total overhead costs to the number of occurrences of the cost driving activity based costing advantages activity, providing a granular approach to cost allocation. Activity-Based Costing (ABC) is a modern approach to cost accounting that provides a more accurate method of allocating costs to products and services than traditional costing methods. This section explores the principles, advantages, and applications of ABC, particularly in the context of Canadian accounting practices.

First, it increases the number of cost pools available to gather overhead costs. Instead of accumulating all costs in one company-wide pool, it pools costs by activity. In an ideal system, the risks of both the fee-for-service system and the capitation model would be minimized while the benefits would be maximized. This is the promise of a value-based delivery system where hypothetically high-quality outcome services are provided in a way that incentivizes necessity of surgery around that episode of care. A major driver in the creation of this value-based system has centered on ABC.7Indeed, ABC has been allotted a major driver on the road to successful implementation of the value-for-service health care plan. ABC allows the hospital system to identify, with a higher degree of precision, the actual costs to deliver a service.

At the next level of intensity, relative value units (RVUs) can be used for staff salary expenses such as nursing, tech, and physician labor. Take your business to the next level with seamless global payments, local IBAN accounts, FX services, and more. One wholesaler gives you hundreds of thousands of dollars in business a year but insists on having you pick up small shipments for delivery to their retailers. If your organization does not have the resources to invest in an ABC system, it may not be worth the effort. For example, if your company makes 10 widgets in one production run, then all 10 types would be grouped as part of one batch.

A wise manager will not focus on how to estimate product costs, but will focus more on why the costs were there in the first place. When intending an activity based costing system this should be utilized as a departure point. Rather than treating all customers as equal, ABC helps in tailoring strategies that may lead to optimizing or sometimes even curtailing services for certain customer segments. It ensures the energy expended is proportional to the profitability of each customer, steering companies towards wiser resource allocation and, ultimately, healthier profit margins. The first step is to identify all activities that consume resources and incur costs.

(i) Production overhead costs are high in comparison to the various direct costs;

(b) It would be difficult to correlate the marginal increase in cost with a particular cost driver. Where selling prices are fixed on the basis of cost plus formula, ABC provides more reliable data for fixing selling prices. It may become apparent that costs are not driven solely by output volumes, and, therefore the focus on managerial attention may be significantly broadened. (f) Improved cost-basis available both at head office and plant level for better decision making. Overheads are not depending upon the output of the product but its complexity and diversity of operations.

• The first one is a machine set-up activity, and the second one is inspecting the same.
• Start by enumerating all the processes involved in the production of a product or in the delivery of a particular service, for instance setting up, inspecting or handling materials.
• It charges overhead costs to different jobs or products in proportion to the cost driving activities in place of a blanket rate based on direct labour cost or direct hours or machine hours.
• Financial planning and analysis (FP&A) provides the insights that drive growth, protect profitability and guide new investments.
• Each activity pool’s total cost is divided by its cost driver to arrive at different rates.
• Armed with this knowledge, you can tweak prices, optimize processes, eliminate waste, and better align resources with profitable activities, thereby boosting your bottom line.

Complexity

In today’s increasingly challenging business environment, the benefits of incorporating ABC into cost management practices should not be ignored. There are numerous benefits to using activity-based costing, which we touch upon below. Management of overhead cost is achieved by coupling the costs to the activities that ‘drive’ or ’cause’ them. It facilitates the preparation of an activity-based budget by providing the management with a clear view on the details of various activities. (d) Strategic cost information of which long-term profitability decision for a product can be taken.

Instead of tracking every single activity, SMEs can focus on the most significant cost drivers. Using cost-effective software solutions and gradually integrating ABC principles ensures that small businesses benefit from accurate cost tracking without overwhelming their financial processes. One of the primary challenges in adopting ABC is collecting accurate and reliable data. Many companies face difficulties in tracking the cost of individual activities, leading to miscalculations. To overcome this hurdle, businesses must invest in robust data collection systems and train employees to record activity-related costs correctly.