Activity-Based Costing

Activity-Based Costing (ABC) is a method of allocating costs to products and services. It is generally used as a tool for planning and control. It was developed as an approach to address problems associated with traditional cost management systems that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. On the other hand, Activity-Based Management (ABM) is an approach to management that aims to maximise the value adding activities while minimizing or eliminating non-value adding activities.

The overall objective of ABM is to improve efficiencies and effectiveness of an organization in securing its markets. It draws on activity-based costing (ABC) as its major source of information and focuses on reducing costs, creating performance measures, improving cash flow and, producing enhanced value products. Yes, information from activity-based costing is better because the traditional costing system do not trace indirect costs, such as salaries and utilities, directly to the product.

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The other problem with traditional costing is that for most overhead activities, the proportions of the activity actually consumed by a specific product, does not correspond with a single cost driver. This is true for most companies in the world now where products are produced by a mixture of manpower and technology. The traditional costing accounting model employs a volume-based driver, such as direct labor hours or machine hours for the assignment of all manufacturing overhead costs (Carl Marx, 2009).

The conventional cost accounting model ends up with a cost of goods sold based on absorption costing and includes only product costs as defined in financial accounting. Nevertheless, weaknesses (including the issue of undercosting and overcosting products) will arise when businesses use traditional costing system. On the other hand, activity-based costing calculates the cost based on actual performance, consumption and expense data extracted from the company’s existing information systems and combined with the knowledge of those directly involved in the delivery of the product or service.

In other word, managers are able to assign costs to activities based on the resources they consume. Hence, ABC allows managers to attribute costs to activities and products more accurately than traditional cost accounting methods. The activities responsible for the costs can be identified and passed on to users only when the product or service uses the activity. In this way, ABC information is more accurate than traditional costing.