Activity-based Costing ABC vs Traditional Costing

They’ll also be able to see how much money they spend on overhead costs versus how much they make from sales of their products or services. This will help them determine if there’s room for improvement in any area where there might be waste or misallocation of resources. This costing knowledge brings informed decision-making at both the tactical and strategic levels and is vital to hospital and health systems’ cost containment efforts.

the key advantage of activity based costing is

The ink and maintenance on the printers would be considered an indirect cost. The cost pool for this example could include purchasing raw materials, which would be ink. Activity-based costing provides a more accurate method of product/service costing, leading to more accurate pricing decisions. It increases understanding of overheads and cost drivers; and makes costly and non-value adding activities more visible, allowing managers to reduce or eliminate them.

Traditional Costing Advantages and Disadvantages

ABC systems are notoriously difficult to install, with multi-year installations being the norm when a company attempts to install it across all product lines and facilities. For such comprehensive installations, it is difficult to maintain a high level of management and budgetary support as the months roll by without installation being completed. Success rates are much higher for smaller, more targeted ABC installations. Convert the results of the ABC system into reports for management consumption. For example, if the system was originally designed to accumulate overhead information by geographical sales region, then report on revenues earned in each region, all direct costs, and the overhead derived from the ABC system. This gives management a full cost view of the results generated by each region, and therefore of the sources of the profits that the region is generating.

James Woodruff has been a management consultant to more than 1,000 small businesses. As a senior management consultant and owner, he used his technical expertise to conduct an analysis of a company’s operational, financial and business management issues. James has been writing business and finance related topics for work.chron,, and e-commerce websites since 2007. He graduated from Georgia Tech with a Bachelor of Mechanical Engineering and received an MBA from Columbia University.

Requires Data from Many Sources

ABC works best in complex environments, where there are many machines and products, and tangled processes that are not easy to sort out. Conversely, it is of less use in a streamlined environment where production processes are abbreviated, so that costs are easy to assign. It assigns costs to activities based on how they contribute to the overall cost of a product or service. This information can be used to identify which activities are most costly and need to be improved.

The identification of cost components is the cost drivers involved in different activities. Cost drivers or cost objects are the factors that impact the cost of a particular activity. It is very important to find out the things that determine the cost of an activity. Traditional costing systems, like absorption costing, are designed to assign costs to individual products or services. This process can be repeated at multiple levels within an organization’s structure.

Objectives of the ABC System of Costing

By focusing higher-intensity costing methods on high-impact areas, a modified activity-based costing approach drives efficiency and helps ensure stakeholders that their time is wisely spent on high-value efforts. Improved transparency of true costs helps establish confidence in the costing data. CIMA Official Terminology describes activity-based costing as an approach to the costing and monitoring of activities, which involves tracing resource consumption and costing final outputs. ABC produces more accurate costing of products by essentially converting broad indirect costs into direct costs of production. It determines the costs of the various sources of indirect costs and allocates these expenses to the specific activities that use them. Finally, businesses facing competitive pressure or looking for ways to improve efficiency may also benefit from using ABC.

  • Let’s say the first unit-level activity is cutting fabric, and the total cost is $10,000.
  • As an activity-based costing example, consider Company ABC that has a $50,000 per year electricity bill.
  • It determines the costs of the various sources of indirect costs and allocates these expenses to the specific activities that use them.
  • Let’s say the total cost for product design for both product lines is $20,000.

Activity-based costing is an accounting method used to assign indirect costs to products. Companies use an activity-based costing system to allocate manufacturing overhead, which refers to the manufacturing costs considered indirect. This method assigns costs into a cost pool, simply a group with individual costs. Businesses could allocate costs like raw materials for a specific cost pool if the cost driver is based on the raw materials needed to create the products. Activity-based costing, commonly abbreviated as ABC, refers to a method used in accounting to assign indirect costs to products. Manufacturing overhead refers to the costs of manufacturing that are considered indirect costs.

Avoidance of Slack Time Reporting

By understanding the actual cost of their products and services, companies can make more informed decisions about pricing, production, and other strategic decisions. So, in short, ABC is a system that assigns costs to activities instead of products or services. This can give businesses valuable insights into where their resources are being allocated and how they can improve their efficiency and profitability.

the key advantage of activity based costing is

This costing system is used in target costing, product costing, product line profitability analysis, customer profitability analysis, and service pricing. Activity-based costing is used to get a better grasp on costs, allowing companies to form a more appropriate pricing strategy. Product pricing is really based on the price that the market will bear, but the marketing manager should know what the cost of the product is, in order to avoid selling a product that will lose a company money on every sale. ABC is very good for determining which overhead costs should be included in this minimum cost, depending upon the circumstances under which products are being sold. By giving a detailed breakdown of costs and the activities that drive them, the accounting system can help you make more informed decisions about pricing, production, and process improvements.