5.1 Meaning of Activity-Based Costing

Activity-based costing (ABC) is a cost accounting methodology that aims to allocate costs to specific activities or processes within an organization. It is a more refined and detailed approach compared to traditional costing methods that typically rely on simple allocation based on direct labor hours or machine hours.

The fundamental principle behind activity-based costing is that activities consume resources, and products or services consume activities. ABC focuses on identifying and understanding the activities that drive costs within an organization and then assigns those costs to the products or services that benefit from those activities.

ABC involves several steps:

1. Identifying activities: The first step is to identify all the activities that take place within an organization. These activities can be both value-added (directly contribute to the production or delivery of a product/service) and non-value-added (supporting activities that do not directly contribute to the final product/service).
2. Allocating costs: Once the activities are identified, the next step is to allocate the costs associated with those activities. This involves determining the cost drivers, which are the factors that cause the activities to occur. Cost drivers can be different for each activity and may include metrics such as machine hours, labor hours, number of setups, or square footage utilized.
3. Assigning costs to products/services: After determining the cost drivers, costs are allocated to specific products or services based on their consumption of the activities. This provides a more accurate representation of the costs incurred by each product or service.
4. Analyzing costs: The final step involves analyzing the costs allocated to products or services. This information can be used to make informed decisions about pricing, process improvement, product mix, and resource allocation.

Activity-based costing provides organizations with a more accurate understanding of the costs associated with their products or services. It helps identify areas of inefficiency, cost drivers, and opportunities for improvement. By capturing a more detailed picture of costs, organizations can make more informed decisions and better manage their resources.

The Merits of Activity Based Costing

The following are the main claims made regarding ABC:  

• More realistic product costs are provided especially in Advanced Manufacturing Technology (AMT) factories where support overheads are a significant proportion of total costs. 
• More overheads can be traced to the product. In modern factories there are a growing number of non-factory floor activities. ABC is concerned with all activities so takes product costing beyond the traditional factory floor basis. 
• ABC recognises that it is activities which cause cost, not products and it is products which consume activities. 
• ABC focuses attention on the real nature of cost behaviour and helps in reducing costs and identifying activities which do not add value to the product. 
• ABC recognises the complexity and diversity of modern production by the use of multiple cost drivers, many of which are transaction based rather than based solely on production volume. 
• ABC provides a reliable indication of long-run variable product cost which is relevant to strategic decision making. 
• ABC is flexible enough to trace costs to processes, customers, areas of managerial responsibility, as well as product costs. 
• ABC provides useful financial measures (e.g. cost driver rates) and non- financial measures (e.g.

transaction volumes). 

• The principle of using activities to trace costs can be applied across a range of  service industries as well as manufacturing firms

Criticisms of ABC 

• A full ABC system with numerous cost pools with multiple cost driver undeniably more complex than traditional systems and will thus be expensive to administer. 
• Much of work is defense related and pricing is on a cost-plus basis hence the need to show accurate product costs. The applicability of ABC to companies has to use market-based pricing and do not have the same high technology  structure has been questioned. 

Many practical problems are unresolved. Examples include:

common cost driver selection, nonlinearity of cost driver rates etc.