Activity-based costing (ABC)

What is the purpose of activity-based costing?

Activity-Based Costing (ABC) is a cost accounting method designed to improve the accuracy of cost allocation by assigning costs to activities based on their actual consumption of resources. Its primary purposes include:

• Improved Cost Allocation: Provides a more precise way of assigning overhead and indirect costs to products, services, or customers.
• Identifying Cost Drivers: Helps identify and measure the factors that drive costs in a business.
• Improved Decision-Making: Enhances profitability analysis, pricing strategies, and operational efficiency.
• Eliminating Waste: Identifies non-value-adding activities to streamline operations and reduce unnecessary expenses.
• Strategic Insight: Supports strategic decisions such as outsourcing, process improvement, and product portfolio management.

What are the six steps in activity-based costing?

1. Identify activities: Determine all the activities involved in the production or service process. Examples include procurement, assembly, and distribution.
2. Assign costs to activities: Gather cost data and assign overhead costs to each activity. These are usually categorised by resource consumption.
3. Determine cost drivers: Identify the factors (cost drivers) that influence the cost of each activity. Common examples are machine hours, labour hours, or the number of transactions.
4. Collect activity data: Measure each cost driver's actual consumption or occurrence for the activities identified.
5. Allocate costs to products or services: Distribute activity costs to products, services, or customers based on their consumption of the cost driver.
6. Analyse and act: Use the information to analyse profitability, eliminate inefficiencies, or adjust pricing.

What are the five advantages and disadvantages of Activity-based costing?

Advantages of ABC

1. Improved Cost Accuracy: Links indirect costs to specific activities, giving a clearer view of resource use.
2. Better Decision-Making: Helps set prices and choose products based on real cost structures.
3. Process Efficiency: Identifies wasteful or non-value-adding activities, helping streamline operations.
4. Customer Profitability Insights: Shows which customers or products bring the most profit.
5. Supports Strategy: Offers detailed cost insights to guide decisions and drive improvements.

Disadvantages of ABC

1. Complex Implementation: Needs extensive data collection, analysis, and ongoing updates.
2. High Costs: Training, software, and setup can be expensive, especially for small businesses.
3. Subjectivity Risk: Choosing cost drivers can be biased or inaccurate if not managed well.
4. Limited Suitability: May not be necessary for simple business models.
5. Data Dependence: Relies on accurate, current data; errors can affect results.

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