The Strategic Role of Activity-Based Costing

Activity-based costing (ABC) is a method for improving the accuracy of cost

determination. It has been adopted by companies in varying industries and within government and
non-for-profit organizations. The usage of these activities is not proportional to the number of units
produced, then some managers will be overcharged and others undercharged under the volume-
based approach. Another consideration is that the volume-based method provides little incentive
for the manager to control indirect costs. The approach that charges indirect costs to product based
on units produced does not provide very accurate product costs and certainly does not provide the
appropriate incentives for managing the indirect costs. The solution is to use activity-based costing
to charge these indirect costs to the products, using detailed information on the activities that make
up the indirect costs
Role of Volume Based-Costing
Volume-based costing can be a good strategic choice for some firms when common costs
are relatively small or when activities supporting the production of the product or service are
relatively homogenous across different product lines. A professional service firm may not need
ABC because labor costs for the professional staff are the largest cost of the firm, and labor is also
easily traced to clients.
Resources Activities, Resource Consumption Cost Drivers, and Activity Consumption Cost
Drivers
An activity is a specific task or action of work done. An activity can be a single action or
an aggregation of several actions. A resource is an economic element needed or consumed in
performing activities. For example are labor and supplies needed or used in manufacturing
activities. A cost driver is a factor that causes or relates to a change in the cost of an activity. A
resource consumption cost driver is some measure of the demand for resources by an activity. It is
the basis for assigning resource costs to a particular activity or cost pool. An activity consumption
cost driver measures the amount of an activity performed for a cost object. It is used to assign
activity cost pool costs to cost objects.
What is Activity-Based Costing?
Activity-based costing (ABC) is a costing approach that assigns resource costs to cost
objects such as products, services, or customers based on activities performed for the cost
objects. ABC recognizes the causal or direct relationships between resource costs, cost drivers,
activities, and cost objects in assigning costs to activities and then to cost objects.
The Two-Stage Cost Assignment Procedure
A two-stage cost assignment procedure assigns resource costs such as factory overhead
costs to activity cost pools and then to cost objects to determine the amount of resource costs for
each of the cost objects.
In the first stage of volume-based costing the factory overhead costs are combined into a
single plant cost pool or several departmental cost pools. In the second stage, a volume-based
rate (based on units produced or hours used in production) is then used to apply overhead to each
of the cost objects.
Steps in Developing an Activity-Based Costing System
Developing an activity-based costing system entails three steps:
1. Identifying resource costs and activities,
2. Assigning resource costs to activities,
3. Assigning activity costs to cost objects.
Benefits of Activity-Based Costing
1. Better profitability measures
ABC provides more accurate and informative product costs, leading to more accurate
product and customer profitability measurements.
2. Better decision making
ABC provides more accurate measurements of activity-driving costs
3. Process improvement
The ABC system provides the information to identify areas where process improvement
is needed.
4. Improved planning
Improved product costs lead to better estimates of costs for budgeting and planning.
5. Cost of unused capacity