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Activity Based Costing

Activity Based Costing (ABC)

For many businesses, CVP analysis is enough to gain a real good understanding of cost, volume, and profit levels in order to set prices. One of its major drawbacks is that it allocates an even share of fixed expenses, whether or not a a particular product or service makes any use of those expenses. Strictly using CVP analysis to set your prices may accidentally artificially inflate the cost of one product line, and deflate the real cost of another. In some cases, this is not a problem, and you will be aware that you are producing one line because it has a symbiotic positive affect on the other, or on your brand as a whole. If you are analyzing your product lines in order to know their real costs in order to make managerial decisions, however, you may have a need to know exactly which costs your individual products/services/activities are responsible for. When that is the case, you will want to do what is called Activity Based Costing.

The central concept of ABC is that a business’s products or services are the results of activities and those activities use resources which generate costs. Cost of resources are assigned to activities based on the activities that use or consume resources and then costs of activities are assigns to costs objects based on the amount of activity performed (using activity consumption cost drivers). ABC therefore recognizes the causal or direct relationships between resource costs, cost drivers, activities and cost objects.

Benefits and Limitations of ABC

Although ABC may provide accurate product or service costs compared to volume-based costing, a business must still be aware of its limitations, including:

  • Cost Allocation – not all costs have appropriate or unambiguous activity or resource consumption cost drivers. Some costs require allocations to departments and product based on arbitrary volume measures because finding the activity that caused the cost is impractical. Examples include costs associated with an IT system, factory insurance, the VP of Finance’s salary and property taxes.

  • Omission of Costs – costs identified in an ABC system are likely to not be the only costs associated with a product or service. Product or service costs do not typically include costs for marketing, advertising, R&D, and product engineering even though some of these costs can be traced to individual products. These costs are not traced because accounting laws require them to be treated as period costs, so additional recourse are needed to trace and allocate costs based on both systems.

  • Expense and Time – an ABC system is extremely time consuming to design and implement. For businesses that have a mature volume based costing system in place, implementing an new ABC system is likely to prove very expensive. Furthermore, like most innovative managerial accounting systems, ABC requires a year or more for successful development and implementation, which will push its ROI back.