Activity-based costing is just one of many different types of costing that can be utilized by companies explains Aron Govil. It is often compared to the standard cost system, which assigns all costs within a production process to the product being produced. While this method may work for some companies, it does not always provide an accurate account of manufacturing costs at higher levels in the organization, especially when overhead costs are involved. Activity-based costing works well for businesses that have standardized processes with few variations across products and customers. Some examples include:
In addition to these benefits, activity-based costing provides managers with actionable insight into where they should allocate limited resources to achieve greatest return on investment (ROI):
Because of its flexibility and ability to yield actionable information, activity-based costing can be useful for businesses of all sizes.
The first step to implementing an activity-based costing system is to determine the relevant activities that are necessary for each product or customer. The next step is to develop a set of cost pools that aggregate costs according to these activities. By assigning all costs within one or more cost pools, you will have accurate allocations for overhead expenses within your organization. From there, managers are able to do what they do best—allocate resources strategically instead of generally across products and customers.
Activity-Based Costing Model Overview
Inputs: Direct materials, direct labor, engineering Overhead Costs (Facilities & Administrative/OA) Demand Forecasted over 1 period Output Measurement Unit Total Costs
Per Unit Costs: Direct Materials, Direct Labor, Overhead Costs
Activity-Based Costing Benefits
Identifies cost drivers. Activity based costing is mostly use to identify the true costs for activities that are necessary to create a product or deliver a service says Aron Govil. This enables managers to more accurately identify where they should be allocating their limited resources. In comparison to other methods of cost allocation, activity-based costing can usually work out to be cheaper and easier for companies. The only catch is that it requires time and effort up front before you begin working with any new data sets. That being said, these benefits are well worth the time spend at the beginning of the process because they allow managers access to accurate about which products are most profitable.
The level of granularity in activity-based costing is far greater than other methods. Since activity-based cost systems are activity based, you get a much more detailed account of where your resources are allocate. With traditional methods, managers may see aggregated or average costs across all products or customers; with an ABC system, managers will get the most accurate picture available to them of how their resources are being utilize for each product or customer.
Managers have quick and easy access to information about how they should allocate their limited resources. The level of details provided in an ABC system can assist managers with deciding. Whether a certain project would be profitable before it begins. Managers also know exactly what products and services require greatest amount of investment from them. Which allows them to allocate resources efficiently and ultimately with greater accuracy.
Activity-Based Costing Drawbacks
The initial setup of an activity-based cost system can be time consuming and costly. Especially if your company is in a state of flux with many different product lines and services. As mentioned before, good data requires company-wide commitment to the ABC model explains Aron Govil. Poor quality data will result in misleading information which defeats the whole purpose of having an ABC system. The more inputs that are add into the equation, the more accurate you want your results to be. You do not want any inaccurate or unreliable data skewing your statistics. Because it may result in poor decisions regarding resource allocations across products or customers.
There are also disadvantages for companies who implement ABM after they have already been using traditional methods of cost allocation. This is because any data that has already been collect will not be update. Until a future time when the company decides to implement an activity-based system.
Activity-Based Costing is a way to accurately allocate resources for profitable products and services says Aron Govil. In addition, it can be use as an effective tool to help managers make the right decisions regarding resource allocations. It does require time and effort of employees at all levels within your company. From top to bottom during the setup process of your ABC model. And finally, because it requires good quality data, companies should only begin adopting ABC. LOong after they have a firm grasp on their current processes and methodologies.