In the traditional methods of absorbing overheads, the costs were allocated to the various products based on the production output, sales, head count or the square foot occupied by product operations. There are several disadvantages of traditional methods. First of all, it leads to under costing and over costing of the products. Due to the arbitrary allocation of overheads by sales or production output, the company is not able to see the hidden costs and profits of the different products. It also distorts profitability analysis. Furthermore, it causes the manager not to pay attention or particular detail to the different company activities and the roles being played by the different employees.
Traditional methods of costing began to lose popularity as it become more competitive in the market place (Kaplan, 1992). There was an increasing need to reduce costs. Secondly, the cost structure in many organizations has changed. Traditional methods do not consider the service related costs of the product yet in the recent pasts these costs have been increasing (Kaplan and Cooper, 1998, 317).
Direct labour used a lot in the traditional methods may not be the best base to allocate overheads since various overhead expenses do not bear any relationship to the labour costs or the labour hours. There are also customer related costs that have come to gain high importance in companies to the increased competition. These are the customer related costs such as after-sales service, discounts, help desk and resolving complaints. Customer profitability is just as important as product profitability (Popesko, 2010). The main advantage of the traditional costing methods is that it is easy to use or implement. All the information isfound in the labour sheets or the sales documents. The method only works for companies that are producing homogenous products.
Benefits and Disadvantages of ABC Costing
Manufacturing and service companies have been moving to activity based costing due to its various advantages. ABC is a process where costs are allocated to different activities using cost drivers. The second step involves the company allocating the costs to the products based on their consumption and demand of the different activities. A product may require different activities in its production process such as design, quality control and purchasing. These activities require certain amount of resources such as labour hours and equipment hours. In the traditional methods, the focus was mainly on prime costs. These direct costs were the only ones which could be directly traced to the product. However with ABC, all costs including overheads can be traced to a particular product be it a service or a good.
One of the advantages of ABC is that it guides the managers to detail all the activities that are undertaken. The activities can then be separated into value adding and non-value adding activities. The performance of the company is enhanced since the non-value adding activities can be eliminated.
The disadvantage with ABC is that it is time consuming as it requires a lot of effort. It is also costly to implement such a system in the organization. There is also the danger of increasing the work in ABC systems where the management seeks to go into more details when it comes to the cost drivers. The managers have to create a balance and calculate the cost benefit ratios. To what point should they go?
If a company conducts an analysis of its products, those ones which are identical in consumption of different processes will not have any over costing or under costing using the traditional method (Kaplan and Cooper, 1989). In such a scenario then it makes no sense for the company to implement ABC costing. Traditional costing methods produce very accurate results in such scenarios. Unfortunately, there are very few companies that produce such products. Most companies produce a wide range of products. They have diversified their risks even though they may be producing related products.
However once ABC is implemented, the company’s performance is enhanced. ABC assists in correctly pricing the products causing the company to know which products are consistently bringing higher profits and the ones that are lagging behind. It may be time for the company to evaluate its portfolio and know which products they should eliminate and those ones to pay attention to as they have a competitive advantage in that area.
With ABC, innovation and creativity is also enhanced as the managers are forced to really brainstorm on the different ways to cut costs and eliminate non-value adding activities in order to increase the profits. Overheads are significant costs of the company total costs where in some companies, the costs are as high as 50%. Allocating such costs arbitrary then is a great risk to the continual profitability of the company.
In implementing ABC, there is training and support that should be offered to the responsible people to ensure its successful implementation. In any company, the accountants, controllers, supervisors, factory site managers and business manufacturing leaders should attend the sessions regularly (Rupp, 1995).
The team members need to understand their responsibilities in terms of recording down the hours and other details that may be needed. This brings in clarity and helps the company to get acceptance from the system changeover from the critical staff (Damitio, Hayes and Kintzele, 2000). ABC also assists in global companies in that the managers can split costs and the profits/margins across the geographic regions. Each country manages its own costs.
With ABC, there is increased awareness and knowledge among the workers when it comes to cutting costs in the company. The approach changes from being a top- down across the departments’ policy to where it is more specific in the different departments of the company. It is now a bottom-up policy where the section head is empowered to cut costs in his or her specific department (Turney, 1991). The staffs therefore learn to prioritize their work and eliminate non-value adding activities. The company may also realize that there is a lot of income that can be gained from the indirect activities. The management also understand how the costs of one activity may be influenced by other subsequent or preceding activities and manage the costs across the departments.
The advantage with ABC is that it empowers the management with power to make better decisions. The company may also be able to reduce the staffs in indirect departments and end up saving in the labour costs (Asada, Bailes and Suzuki, 2000). Companies that gain from ABC implementation are those with heterogeneous structures when it comes to the products, activities and customers. ABC is suitable for companies that have a high number of indirect or support costs.
It is also suitable for manufacturing and service companies with a lot of processes and activities. Thirdly, companies that have a high frequency of different cost drivers will also gain from adopting ABC processes. In any manufacturing company, the company costs can be classified into three. There are the direct costs or traceable costs that can be attributed directly to a product. There are the costs that can be traced to the different activities and lastly there are the untraceable costs. The untraceable costs can be allocated to the products based on either other costs or they may be covered by an increase in the profit margin. The activity costs drivers are three types. There is the transaction based driver where management focus on the frequency or number of transaction. There are also the duration and intensity cost drivers focusing on the time consumed or the direct charge of consumed activities respectively (Drury, 1989).
ABC is not just important in allocating production overheads but other overhead costs such as project management and sales and distribution. ABC costing takes into consideration service costs. ABC costing is also crucial in manufacturing companies in monitoring wastage or defective products. When the company is able to allocate customer complaints and returned products to different products it is able to understand which product line is giving out products that are defective or that do not satisfy the customer? Implementing ABC is a collective activity and it requires the support of everyone (Smith, 1994). It demands a change in attitude and behaviour. Considering all the advantages and disadvantages of ABC, the benefits to be attained outweigh the initial costs and efforts required.
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