The lack of usefulness of activity-based costing Essay

IntroductionToday’s businesses are working in an increasingly complex environment. At present the business environment comprises of high use of advance technology, high quality plus highly complex products and huge range of diversified product portfolio with less product life cycle. Given the present scenario pricing strategy of the product has to be very efficiently designed which includes proper costing of product and then deriving margins over cost of production. A typical composition of cost includes direct material, labor and overhead costs. The cost of components differs as per the product’s life cycle. Direct material cost remaining constant through out the life cycle, cost of labor is more at initial stages and reduces as the life cycle shifts and vice versa takes place in case of overheard cost. Therefore costing methodology places a key role.

In conventional costing Total Cost is sum of Material + Labor+ Overheads .Overheads are allocated to the products on volume based measures e.g. labor hours, machine hours, units produced etc. But in ABC costing activities is defined in an organization. ABC assigns Costs to Products by tracing expenses to “activities”.

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  Each Product is charged based on the extent to which it used an activity. The primary objective of ABC is to assign costs that reflect/mirror the physical dynamics of the businessABC MethodologyAs explained above in ABC Costing is based on activities from which product costing is realized. An example of an organization explained below would show ABC costing methodology.The below mentioned are the activities of an organization and amount spend on those activities of an organization.Accounting RecordsParticularAmountSalaries325000Depreciation185000Power220000Material Cost1500000Travel100000Total2330000The second part shows the identification of activities, the division of the same based on certain assumptions by the organization and thus deriving cost of each department or product. This would reflect the expenses per department and costing of product and thus planning accordingly.ActivitiesSalariesDepreciationPowerMaterial CostTravelTotalBusiness Development65000277503300035000160750Maintaining Present Business81250185002200045000166750Purchasing Material65000370004400020000166000Product 16500055500550009000001075500Product 2487504625066000600000761000Total32500018500022000015000001000002330000Therefore ABC Costing for an organization can establish the true cost of its individual products and services for the purposes of identifying and eliminating those which are unprofitable and lowering the prices of those which are overpriced.

Even though the activity costing is a powerful concept still it lacks usefulness in the industry. Let us understand the draw back behind ABC costing methodologyThe Lack of Usefulness of ABC costingIdentification of Activity Identification of activity and linking it with a product forms the base of ABC Costing. This process is a time consuming and tedious process. There may be lot of overhead which cannot be identified with product and its cost cannot be divided also. Example – security system for a warehouse.

What can be the basis of dividing such a cost? It cannot be floor space as an item costing more may take less space comparing to an item which cost less. I t cannot be duration based? Thus there has to be an assumption which may increase or decrease cost of a product. Implementation of MethodologyThe ABC costing methodology involves- analysis of activities, cost data gathering, tracing of costs to activities, establishment of output metrics; and cost analysis. It means that there has to be proper resources and time to implement it properly.

Implementation would involve mapping of activities with proper cost department. At basic level a worker may be working on two products simultaneously and so his activity so be allocated in both the product in ABC costing methodology. In same way several other overheads have to be properly linked to different products. In large production house having a vast product portfolio identifying an activity and relating it to a product would be a tedious task to implement. Wrongful implementation or miscalculation would result to incorrect pricing strategy and positioning of the product.Change in production StructureAt present as stated above business environment has become very complex and dynamic. Continuous improvement results in change in production structure and activities pertaining to it.

As the activities changes or duration on the product changes the costing would change as per ABC methodology. Every time implementing the ABC methodology as per changes would be a costly affair for an organization.Small Scale OrganizationFor a small scale organization having four to five products in portfolio implementing ABC costing would be a costly affair. It is very much possible that implementation cost of methodology may be disadvantageous for a company to implement it. More ever it may put pressure on controlling systems and on management team. So ABC costing would not suit the small scale organization.Change from Traditional AccountingIt would be difficult for an organization to set up and change from traditional accounting methodologies to ABC costing. As mentioned above ABC costing is time consuming.

Implementation and identification of activity would be a tough call and the change may have retro respective effects on financial statement or strategic change in future outlook which may give incorrect information to the stake holders.ABC costing may provide too much detail – obscuring the bigger informationThere is a danger that ABC costing may shift management’s focus on costing. The decision would be based more on costing rather than other strategic issues like market share, new entrant in a market, and competition in a market and product life cycle of the market, etc.

Project Budgeting based on ABCIn a typical project there are several cost drivers relating to both direct and indirect (overhead) project costs. It is imperative to identify principal cost drivers early in the project planning phase. This will ensure that budget projects are based on accurate information i.e. cost rates, king of cost drivers etc.

Therefore viability and effectiveness of ABC costing hinges upon early identification of the principal cost drivers and control pertaining to it. A failure to do so can jeopardize the project which may not be the case in traditional costing if sensitivity analysis has been done properly.ConclusionAs we judge that ABC costing is a powerful concept and can be of great utilization but it has drawbacks on the foundation it is laid.  Identification of cost drivers and division of the cost among different departments and product make it a difficult task. Cost both in terms of time and money for implementing ABC methodology is very high. A simile between ABC implementation and enterprise resource management can be drawn. Improper implementation of both can lead to fatal results.

Not just the initial cost of implementation is high the change also has to be bought in the methodology as there is change in production structure which may be quite often given the dynamic business scenario.  Therefore we can conclude even though ABC is a powerful concept but there is lack of usefulness of ABC costing. ABC being a powerful concept is just like generation of electricity via lightning which is also a powerful concept but cannot be practically used!!Works CitedØ  Robert S. Kaplan and Steven R. Anderson.

Rethinking Activity Based Costing , January 2005Ø  Value Based Management ,March2008Ø  Jan Emblemsvag . www.emblemsvag.com, May 2008Ø  Brimson, James A.

, Activity Accounting, An Activity-Based Costing Approach, 1998Ø  Cokins, Gary, Activity-Based Cost Management An Executive’s Guide, SAS, 2003Ø  Antos, John and James A. Brimson, Driving Value Using Activity Based Budgeting, 1999;