Activity-Based Costing v. Traditional Costing Systems

Introduction

Activity-Based Costing (ABC) differs from the Traditional Costing Systems in the allocation of manufacturing overheads. ABC does not allocate overheads on the simple basis of time like the traditional approach. It instead determines the actual cost of the overhead before assigning the costs to such activities. A company allocates costs to those units that require the activity. The approach appreciates the fact that at any point, the company’s activities will occasion cost, which will vary with production levels. Therefore, the costs should be assigned to the products that require such activities to arrive at a more accurate measure.

The distinguishing feature of Activity Based Costing is that it links the output of the manufacturing entity to the cost of all activities involved in production. Value-added activities could be determined using this approach.

The manufacturing entity can proceed to eliminate activities, which are not adding value to the product. This will improve the manufacturing system’s performance. In contrast, the traditional costing systems link the direct materials cost and labor costs to the product. While ABC employs an hourly costs system in the determination of the costs of each unit, traditional approaches rely on historical measures or average costs of processes similar to the one employed in determining these costs. This may lead to inaccuracies when factors change. Therefore, ABC is more flexible than traditional costing methods. Managers can use this flexibility to predict costs using scenario analysis (The Economist 2012).

Reasons Top Management May Resist Activity-Based Costing

One of the reasons why management may resist activity-based costing methods is the failure of the implementation team to involve all departments in the process. The non-involvement of other departments in the implementation is likely to lead to resistance. The accountants’ attempts to implement ABC on their own will in most cases lead to resistance due to ignorance of the new system and the lack of input from the other departments that have detailed knowledge of the operations of the firm.. The implementations of the ABC system may also encounter resistance since it results in a shift in the measures used by management in their decision-making activities.

Hence, management must adopt new methods while determining variables, which they use while making manufacturing decisions. Senior managers will also be to use the information afforded by ABC to evaluate the performance of middle-level managers. Managers are likely to resist this new transparency. Another cause of resistance is that ABC introduces a certain level of rigidity in decision-making. Cost estimation requires leeway. Hence, it is more of an art than a science. Decision-making involves other variables apart from costs such as time and quality.

Why Activity Rates Are Important To Management

Activity rates are important to management since they enable management to determine with great accuracy the cost involved in production. The management can quickly estimate the cost of producing at a certain level using activity rates. Activity rates are also important in determining the efficiency of production. The management can use these rates to determine which activities add the most value to the production process. The production process can thus be improved by eliminating non-value-add activities. This allows for a flexible process, which companies can modify to reduce the negative effects of some activities. Activity rates also offer management information, which greatly improves their decision-making ability (Kaplan and Anderson 2007).

Why Activity-Based Costing Approach Is Probably Unacceptable for External Financial Reports (Opinion)

ABC would not be acceptable for external reports due to methods employed in determining the allocations. The use of interviews is likely to lead to costs, which are unrealistic or biased in the eyes of the external financial statement user. Objective and verifiable data should be used instead to increase the confidence of users of such statements. The method used in arriving at costs using ABC is also not acceptable by outside parties. The calculation of activity-based costs may exclude some costs, which are not directly linked to the production process (Shaw 2005).

References

Kaplan, R.S. & Anderson, S. (2007). Time-Driven Activity Based Costing. Harvard: Harvard Business School Press.

Shaw, W. (2005). Managerial Accounting. New York: McGraw Irwin.

The Economist. (2012). Activity-Based Costing. Web.