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Activity-Based Costing System Advantages and

Disadvantages
ARTICLE in SSRN ELECTRONIC JOURNAL JULY 2004
DOI: 10.2139/ssrn.644561

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1 AUTHOR:
Metin Reyhanoglu
Mustafa Kemal University
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Suggested Citation:
Reyhanoglu, Metin (2004), "Activity-Based Costing System Advantages and Disadvantages", 1st July, http://ssrn.com/abstract=644561.

ACTIVITY-BASED COSTING SYSTEM

ADVANTAGES AND DISADVANTAGES
Metin REYHANOLU
Ankara University, Institute of Social Sciences, Research Assistant.
Contact Address: Faculty of Social Sciences,
Department of Business Administration,
Cebeci, 06590 ANKARA TURKEY
reyhanoglu@gmail.com

ABSTRACT
In this article one of costing systems, activity-based costing system (ABC), investigated
with differences of traditional systems. ABC aims that to solve problems created by
conventional costing system. ABC has been become widely used by companies in
beginning of 1980s because of usefulness correct product mix decision, controls overheads
and so on. But like the most of cases, new method also has problems, staff resistance,
difficult to implement, timeliness information, unreliable information. Companies have
been becoming hard to solve these problems as implemented Total Quality Management.
Keywords: Activity-Based Costing, Overheads.

ZET
Maliyet sistemlerinden biri olan Faaliyete Dayal Maliyetleme Sistemi geleneksel
sistemden farkllklaryla birlikte incelemektedir. Sistem, geleneksel maliyet sistemi ile
ortaya kan problemlerin zm iin karlmtr. Faaliyete Dayal Maliyetleme, en
doru rn karmasnn bulunmasndaki kullanl, genel retim giderlerinin kontrol gibi
yararlar dolaysyla iletmeler tarafndan 1980den itibaren kullanlmaya balanmtr.
Ama birok yeni yntem gibi bu yntemin de baz sorunlar vardr; personel direnleri,
uygulama zorluu, bilgilerin gvenirlii ve bilgilerin elde edilmesinde zaman snrll
gibi. letmeler, Toplam Kalite Ynetiminin uygulanmas gibi sz edilen problemlerin
zmnde zorlanmaktadrlar.
Anahtar Kelimeler: Faaliyete Dayal Maliyetleme, Genel retim Giderleri

Suggested Citation:
Reyhanoglu, Metin (2004), "Activity-Based Costing System Advantages and Disadvantages", 1st July, http://ssrn.com/abstract=644561.

INTRODUCTION
Increasing domestic and foreign competition, automation and changing cost structures is
forcing manufacturers to look for a better understanding of their accounting system and to
need real-time information systems. Years ago, typical manufacturers have produced a small
number of products. Labour was the dominant element in cost structure. Nowadays, products
are more numerous and labour are becoming a smaller component of total production costs.
So that companies must take an attention at their traditional and consider a new system.
The goal of management system is to provide relevant and timely information to
management. This supports better management of recourses and improves competitiveness in
terms of costs, quality, and profitability. Cost accounting calculates costs that concerned with
managerial planning and controlling, and requires them because of needs of management
correctness and reliability to compare and to analyse production price.
Product's price consists of costs, which are direct labour, direct materials and overheads.
There is no problem with direct labour and direct materials costs because of their involving
directly to product costs. The problem with overheads is which overheads put in the right
product. Complexity structure of nowadays companies decreases their direct materials and
labour, however their common costs increase instead (Karlf 1993: 34). A cost management
system's one of objectives is that to identify and eliminated non-value-added costs. As its
name indicates, activity-based costing (ABC - activity-based accounting or activity
accounting) is a system that focuses on activities. Activity-based costing can be a part of a
job-order product-costing system or a process product-costing system.

NECESSITY FOR ACTIVITY-BASED COSTING

During 1980s, many managers became dismissed with their costs accounting system
(Horngren and Foster: 151). Some companies began to adopt activity-based costing system
because of dissatisfaction with its existing cost accounting system. There are several reasons
why managers demand it.
First reason is that disadvantages with the method allocates fixed overhead, including
labour, are often arbitrary, not necessarily related and directly associated to production
(Polimeni et al 1991: 567). Using single pools of indirect costs and overhead application
bases such as direct labour hours are no longer considered good enough. In the current
2

manufacturing environment, resources are often unrelated to direct labour. Such

misallocations can lead management effort to place the wrong products.
If companies want to maximise their profits they have two options. One option is cutting
costs. Companies focusing on cutting costs are only asking for trouble. For example,
Thornton Equipment Company needed to lower its overhead cost structure, but indeed they
had trouble because of need of overhead costs (Blaxill and Hout 1991; 93). Cutting cost is not
a solution. Another solution is to correct their products prices. This second reason leads to
management toward the ABC.
Another factor in the move toward ABC systems is related to the information
requirements. Cost accounting systems exist to provide information to help executives in
performing their cost management duties. If managers improve and redesign manufacturing
processes, they want their accounting systems to be tailored to the new processes. If the
activities are managed well, costs will fall and the resulting products will be more
competitive. Companies felt that its existing system was oriented too much toward financial
accounting and provided little information in determining product costs, making product mix
decisions, and evaluating plant performance (Polimeni et al 1991: 1119). Developments in
information gathering technology have made practical the gathering and processing of more
detailed information demanded by activity-based costing (Hilton 1994: 209). With these
reasons by companies moving to ABC costs can be better managed and products more
accurately costed (Roohm et. al. 1992: 59).
Some indicators can signal the need for a new costing system (Hilton 1994: 213):
- Managers do not trust the product costs reported
- Marketing personnel are unhappy with reported product costs.
- Some products are reported profitable, although they are priced with market price.
- Sales are increasing while profits are declining!
- Some products that have reported high profit margins are not sold by competitors.
- Overhead cost rates are very high, and increasing.
- Product lines have variety.
- Company has a small percentage of direct labour.
- Some companies product are priced very low by competitors
3

IMPLEMENTING OF ACTIVITY-BASED COSTING SYSTEM

Activity-based costing system follows two stage procedures. The first stage identifies
significant activities and assigns overhead costs to each activity depending on the proportion
of the organisations resources it uses. The overhead costs assigned to each activity compose
an activity cost pool (Babad and Balachand 1993: 564). After assigning overhead costs to
activity cost pools in stage one, cost drivers are identified that are appropriate for each cost
pool. Then in stage two, the overhead costs are allocated from each activity cost pool to each
product line in proportion to the amount of the cost driver consumed by the product line.
(Exhibit 1)

Exhibit 1: Activity-Based Costing System.

Source: Hilton 1994: 99.

To do this, companies can create new department as an activity accountancy (Karlf

1993: 35). This activity accountancy calculates revenues and costs for each activity. They
manage and control the planned activities. As, companies managers requested they can
organise each activity as a profit centre. Activity accountancys job consists of below order:
1. Resources determinated as based on activities and then planning.

2. Renewable activities are determinated and planned.

3. Costs are determinated as based on functions.
As a result, distinguishing as above provides allocating costs to costs places. An example
of General Motors Company practised this system in their 50 of 193 factories and succeeded
at high production factories with decreased overheads (Karlf 1993: 38).
ABC has also been extended into activity-based management (ABM) (Kilough 1992:
881; Babad and Balachand 1993: 563) to include other considerations, such as customer
profitability, workforce utilisation, distribution channels, and other management issues. Thus
ABC is the information system that displays the cost and profitability structure of products in
an organisation, while ABM describes the actions to improve quality and reduce costs and
cycle time.

An Example for Activity-Based Costing1

Example of Atlas Electronics Company Plc. produce two types of television, named as
Gezer and Sezer. Product of Gezer has a lower production volume and 50.000 units annual
sales. And Sezer has a higher production volume than Gezer, annual sales is 200.000 units.
Gezer system is more multi-functional television and bigger size than Sezer. In this factory,
Advanced Manufacturing System was installed, so that labour costs had been minimised.
Both of products require one hour direct labour for finishing products and company spends
250,000 hours a year. Product Gezer has a high quality and needs more quality control. The
company Product costing is achieved by summing three categories of costs at Exhibit 2. With
this example we will use both costing system, traditional system based on direct labour hour
and activity-based costing system in terms of comparison.

Exhibit 2: ATLAS ELECTRONICS, INC., ANTAKYA - HATAY2

Description: Manufacturing television.
Market: Upper and middle class families, throughout Turkey and exports mainly Syria
and Middle East countries
1

The example is mixture of Hilton 1994: 209; Horngren and Foster: 152-4; Hilton 1994: 206-7; Tan and Tuan
1993: 45-64; Polimeni et al 1991: 567.
2
US Dollar used in the example as a monetary system instead of Turkish Lira because of ease the example. The
company name of in the example does not exist in the reality world.
5

Types of TV: Gezer (for upper class) and Sezer (for middle class)
Gezer
Sezer
Sales of television (per year / units)
50,000
200,000
Direct materials (per unit / $)
400
200
Direct labour (per unit / $)
50
50
Overheads (total a year / $)
-

Total
250,000
75,000,000

a) Product costs; based on direct labour: Rate of overheads allocation can be formulated
as follow:
Annual Overheads
75,000,000 $
=
= 300 $/ hour
Annual Direct Labour Hour
250,000
Then products costs have shown at the below (exhibit 3):
Rate of Overheads Allocation =

Exhibit 3: ATLAS ELECTRONICS, INC.'s Costs ($)

Gezer
Sezer
Direct materials
400
200
Direct labour
50
50
Overheads
300
300
750
550
As seen above with this approach, both products' overheads are equal. Because the
company did not consider factors, effect overheads, and distributed from direct labour hour.

b) Product costs; based on activity-based costing:

Exhibit 4: ATLAS ELECTRONICS, INC.'s Activity Areas
Number of activities
Loadable
Costs (a)
10,000,000
10,000,000
25,000,000
20,000,000
5,000,000
5,000,000
75,000,000

Activities
Material handling
Start station
Machine installs
Manual installs
Quality testing
Packaging
Total Overheads
Total production
Overhead of per units

Total (b)
5,000
10,000
20,000
20,000
10,000
10,000

Gezer (c)
3,000
6,000
12,000
15,000
6,000
5,000

Sezer (d)
2,000
4,000
8,000
5,000
4,000
5,000

Applicati
on Rate
(a/b=e)
2,000
1,000
1,250
1,000
500
500

Total
Gezer
Sezer
(eXc)
(eXd)
6,000,000
4,000,000
6,000,000
4,000,000
15,000,000 10,000,000
15,000,000
5,000,000
3,000,000
2,000,000
2,500,000
2,500,000
47,500,000 27,500,000
50,000
200,000
950
137.5

As business became increasingly competitive, above system will not show real costs.
Different factors are causing or driving costs in individual activity areas, but the accounting
system did not collect information about these differences. It needs to focus primarily on
controlling costs of activity areas.

The first step is to identify the cost drivers. The company after analysed their system,
they have realised that there are six activity areas in the manufacturing facility. Six activities
and their allocation on the products based on application rate at exhibit 4. We can compare
this result with traditional system, based on direct labour hour (exhibit 4).

Exhibit 5: ATLAS ELECTRONICS, INC.'s Costs

Costs According Costs According to
Based on Direct
to Activity-Based
Labour Hour
Costing
Gezer
Sezer
Gezer
Sezer
Direct materials
400
200
400
200
Direct labour
50
50
50
50
Overheads
950
137.5
300
300
Total per unit cost
1,400
387.5
750
550
Target price (20%)
1,680
465
900
660

Under-Over
allocated and
priced
Gezer
Sezer

-650
-650
-780

162.5
162.5
195

What has happened at ATLAS ELECTRONICS, INC. plant? The essence of the problem
is that as seen above in terms of overheads, activity-based costing has changed both product
costs comparing with based on direct labour hour because of their hidden completely by the
traditional. As indicated above with low production volume, but high resources allocation
product Gezers real unit cost increased by $ 650 with activity-based costing. However
Sezers unit cost decreased by $ 162.5 because of low resources allocation. Indeed, Sezer
emerged as an extremely profitable product. The high-volume products basically subsidised
the low-volume line.
Accounting system tended to overcost the intensively competitive high volume product.
It loads too much indirect manufacturing costs on high-volume products and too little on lowvolume products.

ADVANTAGES OF ACTIVITY-BASED COSTING

Activity-based costing has becoming widely uses because of several advantages. First
over all beginning and visible advantage is more useful in measuring product costs to be
obtained more accurately and making product mix decisions and pricing decisions made so
better factory management (Polimeni et al 1991: 1119). The firm was able to identify the

relative profitability of the products and understand cost drivers. The companies will meet
helpful to make decision on capital budgeting process. They can evaluate easily on
investment in new technologies.
The pooling of costs by activities or activity areas provides information that may help
managers to better plan and control costs. Information generated by an activity-based costing
system can also encourage companies to redesign products to use more common parts (Blaxill
and Hout 1991; 100). When activity-based costing system is in use, an activity-based flexible
budget may be developed. Such a flexible is more accurate than conventional budgets,
because multiple cost drivers are identified to explain the behaviour of overhead costs.
In addition, ABC provides insight for the analysis of customer profitability, distribution
channels, brands, region, and other areas that directly affect the profitability of a firm.
Because ABC links performance of particular activities on the organisations resources
consumed (Babad and Balachand 1993: 564). Also the activity-based costing system creates
opportunities to product designers to make for cost reduction.
The prices competitors set for their products are important factors in making decision
whether a company enter a new market. The estimated long-run cost of a product that will
enable a company to enter or to remain in the market and compete profitably against its
competitors is called the target cost. Japanese consumer-product companies often use target
costs in their pricing strategies (Sakurai 1988 quoted by Hilton 1994: 739; Horngren and
Foster: 416). An activity-based costing system can be particularly helpful as product design
engineers try to achieve a products target cost with providing information.
Activity-based costing system generally improves the ability of an analyst to estimate the
cash flows (Hilton 1994: 834). By separating costs into activity pools and identifying a cost
driver into each pool, the analyst can more accurately determine the levels of various costs
that will be incurred.
Harper and et. al. have conducted a project to test the feasibility of applying this method
to purchasing (Roohm et. al. 1992: 59). The test showed that ABC works well when used to
analyse a purchasing department, and the information it provides management with accurate
cost data.
In a JIT production environment a key goal is to reduce inventories and manufacturing
handling activities. Fewer inspections would be required due to the total quality control

(TQC) that often goes together with JIT. Variable manufacturing costs would be lower, due to
saving in direct labour. General factory overhead costs would increase, due to implementing a
new production equipment (Hilton 1994: 210 and 343). But with this type of problem would
be decreased by ABC.

RISING PROBLEMS WITH IMPLEMENTING ACTIVITY-BASED COSTING

ABC uncovers problems with poor quality, poor design, and neglected markets. Kilough
doubts that ABC provides this capability (Kilough 1992: 881). Besides, a similar example has
been used to suggest advantages of JIT and TQM. But when implementing these new systems
some problems have been raised.
According to Blaxill and Haut some companies miss the point; overhead is not only
about cost more fundamentally, its about process (Blaxill and Hout 1991; 93). One of the
obstacles to adopting ABC is that it requires a building managements thinking (Roohm et. al.
1992: 62).
So many companies have found activity-based management so much more difficult to
implement. Ness and Cucuzza estimate that no more than 10% of them now use activitybased management in a significant number of their operations (Ness and Cucuzza 1995: 130).
The other 90% have given up. The problem is that managers often do not think of activitybased management as a major organisational-change program. However, It is. Chrysler and
Safety-Kleen recognised that they were not changing their accounting systems; they were
changing their organisations (Ness and Cucuzza 1995: 131). Like any organisational change
program, ABC runs up against employee resistance. Often ABC is shown a threat to their
jobs. When Safety-Kleen and Chrysler first introduced ABC, they both quickly discovered
that many employees resisted. Some feared ABC would change the existing power structure.
Some did not like ABC coming a tremendous amount of work.
Educating employees at all levels about implementing ABC may be the most difficult
task of all. Measurement has to be tied to the ABC numbers. And the daily decision-making
process often must be significantly altered, too (Ness and Cucuzza 1995: 130). Both Chrysler
and Safety-Kleen mounted major programs to educate employees at all levels. Both began
with one plant as a pilot plant.

Most companies understand how big a job gathering the information needed to set up an
ABC system is after implementing it (Ness and Cucuzza 1995: 135). One reason is that ABC
is much more detailed and complex than standard cost accounting. Traditional systems come
together many costs into a few heterogeneous overhead pools. Under ABC, each of those
pools are often broken into activities, and it may take hundreds of inquires to identify and
gather the information on them. Similarly, an ABC system uses many more statistical
measures than a traditional system. Also activity-based costing system using multiple cost
drivers and overhead rates is more complicated and more costly to use (Hilton 1994: 99).
As Kaplan (1989: 1-3 quoted by Polimeni et al 1991: 1116) indicated that all cost
accounting systems are the problem of timeliness of information. Activity-based costing
could not have solved this problem. A manager might need on a daily or hourly basis.
However, many systems provide information, on a monthly basis. Indeed, there is often a gap
between the time information is reported and the time period that is shown in a report. Also
questionable is important of the quality of the information. Another problem is collecting data
that is so time-consuming, especially in the beginning, what kind of information is that
required to set up an ABC system and where to find it takes a while.
To solve these problems Howell and Soucy recommend that firms adopt multiple cost
accounting systems (Howell and Soucy: 48 quoted by Polimeni et al 1991: 1121). But using
multiple cost accounting system is costly and may lead managers to confuse results. Instead
of them new accounting system should be introduced, for example Time-Based Costing.
Another approach to solve the problem, which is not solve it. That means not to use
complicate systems because of competition leads companies to determine their products price
by market as Japanese companies do.

CONCLUSION
Nowadays companies confronted with increasing intensive competition, booming high
technology and quality, and changing consumers needs. With these problems firms have
improved their manufacturing systems with automation and flexible manufacturing systems to
produce varieties products to meet their customers demands.
Global competition requires that companies continually improve and innovate. New
products must be developed and introduced to replace those that become obsolete. New

10

processes must continually be developed to make production more efficient. But companies
realised that product mix was wrong priced because of old fashion accounting systems.
With these problems, activity-based costing has been implemented in the business with
leading writers Robin Cooper, Robert S. Kaplan, M. Thomas Johnson. The flexibility,
planning and behavioural considerations, that are afforded by ABC make it a significant
improvement over the traditional approaches. ABC has emerged as a tremendously useful
guide to management action that can translate directly into higher profits.
But ABC has also problems such as difficult implementing, costly, staff resistance,
timeless and difficult gathering information and questionable gathered information.

11

REFERENCES
Babad, Yair M. and Bala V. Balachand, Cost Driver Optimisation in Activity-Based
Costing, The Accounting Review, Vol. 56, Iss. 3 , July 1993.
Blaxill, Mark F. and Thomas M. Hout, The Fallacy of The Overhead Quick Fix, Harvard
Business Review, July-August 1991, Vol. 69, Iss. 4.
Hilton, Ronal W., Managerial Accounting, Second Edition, McGraw-Hill, Inc., New York,
1994.
Horngren, Charles T. and George Foster, Cost Accounting (A Managerial Emphasis),
Seventh Edition, Prentice-Hall International Editions.
Karlf, Bengt, ada Ynetim Kavramlar ve Kalknma Modelleri, (translated by Ziya
Ktevin and Eshar Ktevin), Inklap Kitabevi, stanbul, 1993.
Kilough, Larry N., Book Reviews: Peter B. B., Common Cents: The ABC Performance
Breakthrough (Hills-bono, OR: Cost Technology, 1991), The Accounting Review, Vol.
55, Iss. 4, October 1992.
Ness, Joseph A. and Thomas G. Cucuzza, Tapping the potential of ABC, Harvard
Business Review, Vol. 73, Iss. 4, July-August 1995.
Polimeni, Ralph S. and et al., Cost Accounting, Third Edition, McGraw-Hill, Inc., Singapore,
1991.
Roohm, Harper A. and et. al., Yes, ABC Works With Purchasing, Too, Journal of
Accountancy, November 1992.
Tan, Veysi Naci and Tuan, A. Kadir; Ynetim Muhasebesinde Yeni Bir Yaklam: Faaliyet
Esasna Dayal Maliyetleme, ukurova niversitesi ktisadi ve dari Bilimler
Fakltesi Dergisi, Vol. 4, Iss. 1, 1993.

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