Accounting and ion Performance, ABC Essay

8/3/2019 Accounting and ion Performance, ABC Essay

1/5

Introduction

Activity Based Costing System, known as ABC, plays quite vital role in the modern

organizational costing system. In this article, the importance of ABC and difficulties

of implementing ABC are discussed. By introducing what is ABC and what is the

traditional costing system at first, authors here figure out the implement of ABC in the

company of P&G, and then summarize the main advantage of ABC and discuss the

difficulties when apply it in the daily usage.

The advantage of Activity Based Costing System

Activity Based Costing System is focusing on the individual activities as thefundamental cost objects. In other words, ABC calculates the costs of individual

activities and assigns costs to cost objects basis on cost drivers. By concentrating the

indirect costs, especially the overheads, ABC tries to seek a greater level of detail in

understanding how organization uses its resources. Apart from the traditional costing

system with only one cost pool and one cost driver, ABC creates smaller cost pools

linked to the different activities. And for each activity-cost pool, a measure of the

activity performed serves as the cost-allocation base (the cost in each cost pool have a

cause-and-effect relationship with the cost-allocation base). In some cases, costs in a

cost pool can be traced directly to products (thus improves cost accuracy, because it

makes no assumptions about the cause-and-effect relationship between the cost pool

and cost-allocation base.) To apply ABC, the overhead cost drivers should be

determined at first, and then activity cost pools are needed to be created. By allocating

all overhead cost to one of the activity pools, an overhead rate can be then calculated

for each cost pool. Overhead costs are then allocated to each product according to

how much of each base the product uses

quite different from the ABCtraditional costing system only traces one cost drive.

Direct labor and direct materials are often used to measure the overheads. Thats why


2/5

traditional costing system will distort the cost and provide inaccurate information.

Traditional cost systems frequently understate profits on high-volume products and

overstate profits on specialty items. The advantages of ABC are quite obvious. ABC

divides costs into different parts with different cost drivers, amending the distortion

by traditional cost system, making the cost of products more precise. This correction

helps managers make better decisions and avoids the under-costing and over-costing

at products. Meanwhile, ABC promotes the organization increasing the diversity of

products. Because nowadays modern organizations dont satisfy produce only one or

two products, when they product more different kind of products, ABC system can

help them calculate the exact cost of each product and then also promote organization

increase the diversities. Whats more, in complex companies, ABC, by decreasing indirect cost and then increasing the gross profit (advances in product and process

technology), helps the organization manage the costs and profits. However, the

application of ABC can lead to more competitive in product market because the costs

are more exactly, no under-costing or over-costing.

ABC system shows its advantages over traditional costing in many situations. First of

all, in such companies which have a wide variety of products and cost drivers as

Unilever and P&G, it is crucial for managers to have insights into cost structure for

making and selling their diverse products. Because each product has different

production process and incur different activities, only ABC system can provide

managers with correct cost data.

Moreover, given the complexity of activity cost pools, cost drivers and cost allocation

bases in complex companies, ABC system is the useful tool to reduce costs and

improve efficiency. Once managers have all information about the costs of different

important activities and factors causing costs to be incurred in hand, they are able to

evaluate whether particular activities can be reduced or eliminated. Similarly, due to

the nature of diverse products, sophisticated cost structure may blind managers to the

profitability of some businesses which seems to incur losses. ABC system therefore is


3/5

definitely vital to make decisions on whether any product business should be reduced

or expanded in complex companies.

Additionally, ABC system can be used for internal planning and managing activities.

It specifies cost for each individual activity and provides managers with feedback on

how well activities are managed by comparing budgeted and actual costs for that

activity at the year end. This is extremely important especially in a competitive

market where managers have to control price in order to compete with other rivals.

Difficulties arising in implementing ABC

There are several difficulties associated with the implementation of activity basedcosting. These difficulties may arise due to the nature of the activity based costing

itself or due to the limitations which relates to the ABC. The difficulties relating to the

nature of ABC includes: 1) the time and effort needed in ABC implementation; 2) the

cost related to implementation of ABC; 3) the complexity of ABC itself. The other

aspect of difficulties of implementing ABC relates to the limitation of ABC which is

the suitability of ABC being implemented in a company.

The first and foremost difficulty encountered when implementing ABC system is that

the implementation process would require a significant amount of time and effort.

This is the matter because when implementing ABC then the company would have to

conduct thorough research and analysis of each activity in each department in order

to get sufficient data and information to understand the cost structure and more

importantly each cost driver. This effort of research and analysis is much time

consuming as well as would include the contribution and cooperation of the

employees and management of each activity in each department.

The second matter would be the cost of implementing ABC system. It has been

mentioned earlier that the implementation of ABC would require much effort and time

in the process of identifying the cost structure and the cost driver of each activity in


4/5

each department. Hence, this would lead to the higher cost incurred not only to the

understanding of cost but also the implementation of ABC itself once the ABC system

has been decided upon. The main reason for this is because most ABC system

requires specific ABC system software to be implemented to support the ABC system

of the company due to the complexity of the ABC monitoring system relative to the

complexity of the ABC system itself.

The ABC is a system where the costing derived from the cost drivers for each activity

when allocation overhead to each department or activity. As mentioned earlier, it

would require much data and information to understand the cost structure and each

cost driver. Hence, given the amount of information needed, this gives rise to thecomplexity of the ABC itself. ABC costing data can be easily misinterpreted and must

be used very carefully in decision making. Management must carefully select only the

data and information which are relevant to the costing of each activity in each

department.

There are limitations related to the implementations of ABC and the most important

one would be the suitability of implementing ABC systems. It has been stated earlier

that ABC not only takes in much time, effort, as well as resources, hence, we can

imply that only certain types of companies would benefit from ABC system after

weighing their cost-benefit aspect. Companies that are large in size and bureaucracy

aspect would benefit from ABC because these companies would tend to have a large

ratio of overhead in comparison to their total cost. Companies which would also

benefit from ABC would be those that have numerous product lines and their products

differ greatly in volume of production. This is so because the probability of

over-allocation or under-allocation of overheads would be higher in these companies

and ABC would become the solution in order to achieve more accurate allocation of

overheads to each product which in turn would increase profitability of the companies.

However, ABC would be less useful it were to be implemented in service companies

because the cost driver would be more difficult to identity and it would be relatively


5/5

inaccurate as tracing cost to services in general is more difficult. ABC would also be

found to be less of use when implemented in small companies because generally the

proportion of overhead would not be significant relative to the total cost itself.

Furthermore, small and medium may find that implementing ABC would be too

costly and time consuming when weighing between the cost and benefits from the

ABC system.

Conclusion

ABC system is believed by many as the solution to over-allocation or under-allocation

of overheads to each product which will then lead to more accurate costing and better

decision making. Nevertheless, ABC still has its drawbacks and limitations such asbeing costly, time consuming, and sometimes even causes misinterpretation of data if

not used very carefully but all in all, activity based costing system has contributed to a

better costing system for the major companies all over the world.

Documents

Accounting and ion Performance, ABC Essay