FREE ESSAY ON ACTIVITY BASED COSTING

ACTIVITY BASED COSTING

The Use of Activity Based Costing
By
Joseph P. Milazzo
Masters of Business Administration
Hawaii Pacific University
Fall 2000
Activity based costing (ABC) is a relative new way to allocate costs to specific
processes and services. This system assures that the costs are accurately distributed to
the products or services that generated them. ABC illustrates costs more accurately,
giving management insight to the cost associated with certain business activities. ABC
extends the decision-making skills of management by expanding on traditional costing (job
order costing/process order costing) techniques. However, since ABC's introduction in the
1980's, many corporations are not using ABC, despite gained managerial decision making
capabilities. Even by the mid-1990s, ABC's use has not spread throughout the accounting
industry and its use is not obvious (Selto & Jasinski, 1996). The following article will
discuss the pros and cons of the ABC method. 
Traditional Techniques
ABC is an extension of traditional product costing techniques. These techniques are
called job order costing and process order costing. A job order costing system arranges
costs for each unit as it goes through a production process. A process cost system
collects costs in work in progress account. The numbers of units worked are recorded for
the accounting period. 
These systems alone do not accurately illustrate costs incurred. Instead, these two
costing techniques generally lump costs into 3 main categories (cost centers). These
three categories are direct materials, direct labor and overhead. Cost drivers are then
assigned to represent the relationship between the cost and the process it is allocated
to. 
Activity Based Costing
ABC provides a better map of the costs of manufacturing products or distributing
services. ABC uses a multitude of activity centers, which are the equivalent to the
previously mentioned traditional cost centers. Each of these activity centers has its own
cost driver and driver rate. ABC identifies many different costs to products by adjusting
the cost driver and driver rates to specific activity centers. This process avoids across
the board allocations of cost. For example, a product, which takes up .03% of space in
the warehouse, would require .03% cost absorbed by product sales revenue. If the
depreciation unit requires 5% cost to replace equipment at a latter date, 5% is the
driver rate for that particular product. Unit, batch and product level costs can be
determined with ABC. 
The following steps can summarize the ABC process. The first step is to identify the
activities that consume resources and allocate costs to those activities. For example,
purchasing materials, record keeping, labor, materials, miles driven, machine hours and
number of customers served are activities, which consume resources and needs costs to be
assigned to them. 
The second step is to distinguish the cost drivers that are related to each activity. For
example, if machine hours an activity used in the process, then the number of hours used
in production of one unit would be the particular cost driver rate. The last step is to
allocate costs to products by multiplying the cost driver rate by the number of cost
driver units consumed by the process.
Pros
There are many inherent strengths in the ABC model. The ABC model allows costs to be
allocated to many different activity centers. Few corporations can focus on
undifferentiated product lines and be successful. Having multiple product lines means the
company has multiple cost drivers associated with each different product line. ABC is
helpful in selecting which products are successful and which ones should be eliminated.
Accurate cost information is key in determining the actual costs of frequent product
changes. This cost is important because costs can be a good indicator of the
justification or termination of varying product lines. 
Product lines have become more complex. Product lines of past were much simpler. For
example, the Model T Ford came in one style and one color, black. Today, Ford cars have
many different colors and styles. These different styles all have different cost drivers
and activity centers. ABC illuminates hidden costs when high volume sales are not present
and product differentiation is. This is advantageous because unprofitable lines can be
replaced with lines that are profitable.
Not many years ago, labor comprised 25 to 50 percent of a product's cost. However, since
the 1960s, labor is increasingly less involved in the production process. For example,
the textile industry replaced 100-year old shuttle looms for European air-jet looms,
doubling output with less labor. In steel, the Nucor corporation used continuous casting
machines to yield labor costs of $60/ton verses traditional steel's $130/ton. Labor cost
today is infrequently the driving force behind costs it was during the development period
of cost accounting (1930's). Instead, indirect costs have replaced labor as the dominant
portion of costs for some products (Kelly, 1991). To use labor as the major basis for
allocating as job costing or process costing accounting does, may lead to inaccurate
decisions by management. 
Cons
The accounting profession has largely overlooked ABC. Among reasons cited for low
adoption were employee resistance and the organizational changes essential with the use
of ABC (Ness & Cucuzza, 1995). Some trace the source of hindered adoption of ABC to
technical as well as cultural issues. Others feel that ABC would be more widespread in
industry if it were marketed better by the accounts themselves (Brausch, 1992). 
There are several reasons for ABC low adoption rate. Complexity is an obstacle to
implementing ABC. ABC requires detailed records of the costs associated with producing
products and services as compared to traditional methods. This detailed record keeping
requires more effort from the accountants and is more time consuming. The complexity of
ABC can contribute to more errors. ABC can require more time to check and recheck to
uncover errors. ABC generally requires more effort on the part of the accountant verses
traditional methods and reduces the adoption rate of ABC. 
Another reason for not using ABC is the increased economies of scale. Many corporations
are standardizing their products to reduce the costs to manufacture them. For example,
Coca-Cola distributes its products in many different countries. The product varies very
little in respect to packaging and manufacturing. Traditional methods of accounting can
assign costs more easily, quickly and accurately for those products that have little or
no product variation. 
Conclusion
ABC is a valuable tool in calculating the costs of producing varying product lines. These
differing product lines require more extensive accounting practices than traditional
costing methods provide. The information obtained from ABC can help promote product lines
that managers feel are profitable between those which should be eliminated. Labor is less
frequently the major ingredient in the production process. ABC addresses this concern by
examining and illustrating the overhead costs associated with particular activity
centers. ABC describes these over head costs more accurately and is beneficial when
increasingly more complex manufacturing processes are used. Adoption issues should be
addressed to implement ABC method when costing decisions matter to managers.
Bibliography
References
Brausch, J.M. Selling ABC: New Cost Systems Can Flounder if They Are Not Marketed.
Management Accounting, February 1992, pp. 42-46.
Geishecker, M.L. New Technologies Support ABC. Management Accounting, March 1996, pp.
42-48.
Kelly, K. A Bean-Counter's Best Friend. Business Week, October 25, 1991, pp. 42-43.
Ness, J.A. and T.G. Cucuzza. Tapping the Full Potential of ABC. Harvard Business Review,
July/August 1995, pp. 130-131.
Selto, F.H. and D.W. Jasinski. ABC and High Technology: A Story with a Moral. Management
Accounting, March 1996, pp. 37-40. 17