The benefits and limitations of activity based costing for your company
Regardless of the industry you are in: knowing the root causes of your business success will help you to further increase that success! So, knowing what type of patients or procedures bring you the most profit in your hospital is similar to knowing the margin of certain loan types at a bank. Let’s look at the benefits and limitations of activity based costing to help determine the success of your business.
Benefits of Activity Based Costing |
Limitations of Activity Based Costing |
|---|---|
More precise allocation of overhead and indirect costs |
Implementation requires significant resources and expertise |
Shows the true cost and profitability per product |
Needs more data and ongoing upkeep than traditional costing |
Reflects customer profitability properly |
Cost drivers are not fixed and require regular review |
Pricing that reflects the true value of your offerings |
Distorted results if cost drivers are not correctly identified |
Shows which activities drive costs and where improvement potential lies |
Traditional costing aligns more closely with GAAP |
In short: the main benefits of activity based costing are more precise cost allocation and a true view of product and customer profitability; the main limitations are the resources, data, and ongoing upkeep the system requires.
What is activity-based costing?
Activity-based costing (ABC) is a cost accounting method that allocates costs across activities instead of products, allowing you to determine which activities drive costs and where improvement potential lies.
Unlike traditional costing, which spreads overhead uniformly across all products, ABC traces indirect costs to the products and services that actually consume each activity and that is exactly where both its benefits and its limitations come from.
The benefits of Activity-Based Costing
Compared to traditional costing methods, ABC offers a more granular approach, tracing costs from resources to activities and finally to products. That granularity is what produces the six benefits below.
ABC allocates overhead and indirect costs more precisely
Whereas most companies and governments have a good insight in the direct attributable cost of their products and services (e.g., bills of materials, man hours…), most struggle with all indirect costs. With the increase of technology, the ‘overhead’ costs are increasing. This calls for more precise calculations. ABC answers that call: it assigns overheads to an expanded number of cost pools and uses new bases for cost allocation, so indirect costs become attributable to the specific activities causing them, rather than spread as a general add-on for every department.
ABC shows the true cost per product
The problem with traditional costing systems is that products and services will cross-subsidize each other without you knowing. This leads to the cost of ‘easy’ products and services being overestimated and ‘difficult’ products being underestimated.
Take a car manufacturer that produces a basic vehicle without any extras, as well as a high-end SUV with many extra features. The manufacturer probably has an insight into the material cost differences between the two models. But what about the cost of the sales team? Or the cleaning staff? It’s plausible the sales team spends more time per SUV in comparison to the basic model. In most traditional cost systems, sales staff cost is simply divided by the number of vehicles sold or the revenue. With ABC, you can map the activities of the sales staff to the right vehicle. A similar situation applies to the cleaning staff: due to extreme quality tolerances, the level of cleaning should be much higher at the SUV production. Will this be reflected in the cost price? With ABC, it is. Even two products with the same direct hours or bill of material can turn out to have very different true costs.
ABC reflects customer profitability properly
Activity-based costing also reveals the true cost of each customer. Take an insurance company: let’s say you have customers of type A. They always use online channels to communicate, hardly claim anything, and are satisfied with the services. As opposed to the type B customer, who requires a lot of admin work, always uses the phone for communication, and has high and complicated claims. Revenue per customer may look similar, the cost to serve is not. ABC allows you to make sure the profitability of those clients is reflected properly.
ABC enables pricing that reflects true value
ABC provides accurate and granular product cost insights, enabling you to establish pricing strategies that reflect the true value of your offerings. With a comprehensive understanding of the costs associated with activities and resources, you can identify where improvements can be made to enhance product profitability, or pursue pricing that better aligns with your cost structures. This is a real competitive advantage.
ABC shows which activities drive costs
Because ABC makes activities and their costs explicit, it reveals the factors triggering each cost, enabling you to manage and reduce costs effectively. The insights allow you to optimize resource deployment, enhance productivity, and minimize operational waste: expensive activities that add little value become visible, instead of hiding inside a general overhead rate.
ABC supports budgeting and strategic planning
Activity-based information enables nuanced budgeting and performance measures that surpass traditional accounting methods. It gives you a better understanding of the performances across your business and supports data-driven decisions in product design, product mix, and resource allocation. It helps align financial goals with overall business objectives.
Utilizing the benefits of activity based costing, you can properly reflect costs and profitability.
The limitations of Activity-Based Costing
Implementation requires significant resources and expertise
One of the key critiques leveled against ABC is the complexity inherent in implementing and maintaining the system. The process of identifying the relevant cost pools and cost drivers, as well as their relationships and values, requires significant resources and expertise, which may pose a barrier for smaller businesses or those with limited resources.
ABC needs more data and ongoing upkeep
ABC is more detailed than traditional costing, and it needs more data and upkeep. To attribute overhead costs precisely, you have to judiciously analyze their source and consumption patterns, which can be intricate and subject to change. Regularly re-evaluating and adjusting these attributions is essential to ensure continued accuracy. This is an ongoing commitment, not a one-time exercise.
Cost drivers are not fixed
Cost drivers, the elements responsible for indirect cost allocation in ABC, are not fixed and require regular review and adjustment to reflect true consumption rates. This presents a paradox: although pre-determined cost drivers are fundamental to ABC implementation, their evolving nature demands constant monitoring and updating. If you’d like to reduce this maintenance burden, time equations and capacity cost rates offer a way out. Read about time-driven activity-based costing.
Wrong cost drivers distort results
Another challenge lies in the potential for inaccuracies if cost drivers are not correctly identified or applied. This can lead to distorted cost allocations that do not accurately represent the underlying cost structures. Such inaccuracies can have wide-ranging implications, potentially affecting product profitability assessments, operational efficiency evaluations, and overall business strategy development.
ABC requires separate GAAP reporting
ABC is a management accounting tool. Traditional costing offers greater alignment with GAAP and industry norms, which is why organizations typically run ABC alongside their statutory reporting. That dual requirement adds reconciliation work.
Is ABC costing worth it for your organization?
The right choice depends on priorities: implement ABC when accuracy and strategic decision-making matter most; traditional costing when simplicity and GAAP alignment take precedence.
ABC is worth implementing when most of the following are true:
- Overhead and indirect costs are a large and growing share of total cost
- Products, services, or customers differ significantly in the work they require
- Margins reported by the current system don’t match management’s intuition
- Pricing, product-mix, or cost-reduction decisions are being made on those margins
- You can commit to maintaining the model or automate it with activity-based costing software
For some businesses, traditional costing remains the sensible choice: it offers simplicity in setup and maintenance, a less data-intensive approach for overhead allocation, and lower costs and resource requirements for implementation. If your overhead is small and your products are similar, a general add-on produces roughly the same answer without the extra complexity.
FAQs
What is the purpose of activity-based costing?
The purpose of activity-based costing is to assign overhead and indirect costs to products and services based on the specific activities required to produce them.
What are the advantages of ABC costing?
The purpose of activity-based costing is to assign overhead and indirect costs to products and services based on the specific activities required to produce them.
What are the disadvantages of ABC costing?
The main disadvantages of ABC costing are resource-intensive implementation, ongoing data collection and upkeep, cost drivers that require regular review, distorted results from wrongly chosen drivers, and no GAAP compliance for external reporting.
Is activity-based costing better than traditional costing?
ABC is more accurate whenever overhead is significant and products consume resources unevenly, because it traces costs from resources to activities to products instead of applying a uniform add-on. Traditional costing is simpler, less data-intensive, and aligns more closely with GAAP.
