Activity Based Costing: Advantages and Disadvantages

This assignment explores the concept of Activity Based Costing (ABC), highlighting its benefits and limitations. It delves into the advantages of ABC, such as improved cost allocation accuracy and better decision-making, while also addressing the challenges associated with its implementation, including data collection complexities and potential resistance from employees. The document concludes by emphasizing the importance of ABC in today's competitive environment for companies seeking efficiency improvements.

Activity Based Costing Vs. Conventional Costing

a) Jackson Ltd. currently uses a single plant wide overhead rate based on direct labour
hours. The overhead rate is calculated as follows:
Predetermined overhead rate = total manufacturing overhead / total number of direct labour
hours
Total manufacturing overhead = $816,000
Total direct labour hours
Fred Martha
Production quantity 1000 units 5000 units
Direct labour 2 per unit 3 per unit
Total direct labour hours 2000 hours 15000 hours
The total direct labour hours are 17000.
Predetermined overhead rate = $816,000 / 17000
= $48
Cost per unit as per the conventional approach:
Fred Martha
Direct Material per unit $40 $60
Direct labour per unit $30 $45
Manufacturing overhead 2 hours 3 hours
Pre-determined overhead rate $48
Manufacturing overhead per
unit
$96 $144
Total cost per unit $166 $249
b) Cost per activity for each activity pool
Activity cost
pool
Manufacturing
overhead budget
Cost driver Budgeted level
of cost driver
Cost per
activity
Machine related $450,000 Machine hours 9000 hours $50

costs
Set up and
inspection
$180,000 Number of
production runs
40 runs $4,500
Engineering $90,000 Engineering
change orders
100 change
orders
$900
Plant related
costs
$96,000 Square footage
of space
1920 sq. ft. $50
c) Product cost per unit for Fred and Martha using activity based costing
The product cost comprises of the material, labour and manufacturing overhead costs. The
manufacturing overhead costs for each product in activity based costing are calculated by
calculating the cost per activity. The total of activity cost is the manufacturing overhead cost.
1) Machine related costs
Fred Martha Total
Machine hours 4 hours 1 hour
Production quantity 1,000 units 5,000 units
Total machine hours
required
4000 hours 5000 hours 9000 hours
Cost per machine hour $50 $50
Machine related costs $200,000 $250,000 $450,000
Cost per unit $200 $50
2) Set and inspection costs
Fred Martha Total
Unit Batch 50 units 250 units
Production quantity 1,000 units 5,000 units
Number of production
runs
20 runs 20 runs 40 runs
Cost per production
run
$4500 $4500

Set up and inspection
costs
$90,000 $90,000 $180,000
Set up and inspection
costs per unit
$90 $18
3) Engineering costs
Fred Martha Total
Engineering change
orders
75 change orders 25 change orders 100 change orders
Engineering cost per
change
$900 $900
Engineering costs $67,500 $22,500 $90,000
Engineering costs per
unit
$67.5 $4.5
4) Plant related costs
Fred Martha Total
Square feet of space
used
1536 sq. ft. 384 sq. ft. 1920 sq. ft.
Cost per sq. ft. of
space
$50 $50
Plant related costs $76,800 $19,200 $96,000
Plant related costs
per unit
$76.8 $3.8
Product cost per unit for Fred and Martha are presented below:
Basic Advance
Direct material per unit $40 $60
Direct labour 2 hours 3 hours
Direct labour cost per unit $30 $45

Manufacturing overhead
Machine related costs $200 $50
Set up and inspection costs $90 $18
Engineering costs $67.5 $4.5
Plant related costs $76.8 $3.8
Total Manufacturing overhead $434.3 $76.3
Cost per unit $504.3 $181.3
d) The company prices its products at 120% of the manufacturing costs of the product.
Hence, the price of each product is as follows:
Fred Martha
Total Manufacturing cost $504.3 $181.3
Price of product $605.2 $217.6
e) The price of the products as per the conventional approach is as follows:
Fred Martha
Manufacturing cost $166 $249
Price of product $199.2 $298.8
Here we see that the price both Fred and Martha have been miscalculated in the conventional
approach. Fred has been under-priced by 244% whereas Martha has been overpriced by 27%.
This is due to the incorrect allocation of the manufacturing overhead costs. The direct
material cost and direct labour cost remain the same under both costing methods i.e.
conventional costing and ABC costing. The difference arises in the allocation of overhead
costs under both costing systems.
Under the conventional costing system, the manufacturing overhead was allocated on the
basis of plant wide rate based on the direct labour hours. Since Fred used less labour hours (2
hours) as compared to Martha (3 hours), hence Fred has been allocated lower overhead costs.
However, under the activity based costing, the manufacturing overhead costs have been
allocated based on the use of each activity by the products. The total overhead cost has been

segregated into various activities due to which the overhead has been incurred. Four activities
have been identified which include machine related costs, set and inspection costs,
engineering costs, and plant related costs. For each activity, a cost driver has been identified,
and based on the cost drivers; the overhead has been allocated to the products. The cost of
each activity has been calculated, and depending on the usage of the activity by the products,
the cost of activity for per unit of the product has been calculated. The per unit cost of all
activities has been added up to arrive at the manufacturing overhead per unit for each
product. For all the activities, product Fred has higher per unit activity cost. Even though the
production units of Fred are only 1000 whereas for Martha it is 5000 units, still the total
activity costs are higher for Fred. Set and inspection is the most expensive activity costing
$4500 for each set up. Fred requires a set up for each 50 units whereas Martha requires a set
for each 250 units. This shows the efficiency of producing Martha. Likewise for all other
activities, the per unit cost is higher for Fred. Thus this has led to a higher total
manufacturing overhead cost for Fred as compared to Martha.
Currently, the company has priced Martha at $298.8 under the traditional costing system,
whereas the competitors have priced it at $230. Hence, the sales of Martha have been
reducing entirely on the basis of higher pricing. But after applying activity based costing, the
price of Martha will go down to $217 at the same profit level as before. This will make
Martha even cheaper as compared to the competitors and thus the sale of Martha will
increase. Thus we see that ABC costing has addressed the problem of the company has
ensured correct pricing of the products.
f) Activity based costing (ABC) is a more refined way of allocating overhead to
products, jobs, processes to ascertain accurate product costs (Saxena & Vashisht
2010) It is an alternative to traditional costing where the selection of base to apportion
overhead would generally prove wrong as the same base would apply to all the
products (Salem & Mazhar 2014). If Jackson Ltd. Introduces ABC costing, not only
will the accurate pricing of products happen, there would be other benefits associated
with the implementation of the ABC costing system. These are discussed below:
i) More accurate product costs – since the companies are able to identify more
accurate product costs, hence it helps in better pricing and product mix decisions.
The price should be able to cover all direct and indirect costs so that realistic
selling price can be fixed

ii) Helps in better planning and controlling costs – when a company uses activity
based costing, am activity based flexible budget may be prepared. These budgets
are better than the conventional budgets prepared under normal circumstances
because the behaviour of the overhead costs can be well explained by the multiple
cost drivers identified under ABC system (Reyhanoglu 2004)
iii) Better decision making – since more reliable data on the cost of the product is
available, hence the managers can use this information to make more informed
and accurate decisions. The information may be available in forms of various
reports which may be available as per the use of managers.
iv) Better estimation of cash flows – under ABC costs are segregated into various
activity pools, for each activity, cost drivers are identified, hence it becomes easy
for the managers to determine the various levels of costs that will be incurred for
the products, processes and jobs (Hilton 1994)
v) Use of excess capacity and cost reduction - ABC helps in cost reduction as it
helps in distinguishing between costs that add value and vice versa. The spare
capacity can be identified (Rohit n.d.) The resources required under ABC can be
compared by the resources currently being used and costs can be reduced by
eliminating the use of resources not required under ABC.
vi) Helps in waste elimination – in order to maintain its performance level, a
company must continuously strive to improve. The ideas of improvement should
come from front line employees who are closest to the production process and
from customers (Raman 2010) the costing system should be such that it provides
feedback to enable growth capabilities. ABC provides information at both activity
level and cost driver level; this information can be used to eliminate wastages.
vii) Helps in performance appraisal – the performance appraisal of the responsibility
centres can be done using ABC costing. The transaction volume for each cost
driver will give the activity usage of the responsibility centres and on the basis of
this, performance appraisal can be made.
g) Even though ABC offers a number of advantages, there are certain limitations
associated with it. These are discussed below:
i) Difficulty in implementing – it is very difficult to implement ABC costing system in
an organisation because it faces a lot of resistance from the employees as it is shown
as a threat to their jobs. Managers find it very cumbersome to implement this costing
system as it is like changing the whole organisation. Also ABC involves tremendous

work coming with it and hence is resisted by most of the employees of the
organisation.
ii) Difficulty in gathering information required setting up ABC – under traditional
costing, the costs are pooled into heterogeneous overhead pools. However, under
ABC, the overhead pool is broken down into various activity pools. A lot of
detailed analysis is required to identify such activities. ABC is more complicated
and costly as it uses multiple cost drivers and overhead rates (Friedman & Lyne
n.d.)
iii) Problem of timeliness of information – all the previous costing systems face the
problem of not providing information in a timely manner. ABC also does not
solve this problem. A manager may require data on an hourly basis; however most
of the information is available on a monthly basis. Also there is a gap between the
time the information is recorded and the time it is provided in the report.
iv) Not suitable for small manufacturing companies – since ABC is costly to
implement, small companies cannot afford to implement them. Also the amount of
information required is huge, which makes it difficult for small companies to
break the information into such small parts. Hence it us mostly suitable for big
companies.
Even though ABC has some disadvantages, however, the advantages offered are more than
that. In a world of increasing competition, technology and varying consumer requirements, it
is important for companies to continually innovate and improve themselves. The production
should be made more efficient by elimination unnecessary processes and wastage (Rof &
Andreica 2011) ABC tends to solve most of these problems.
Bibliography
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