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What Is Activity-Based Costing?
Activity based costing (ABC) was originally developed by Cooper and Kaplan in 1988 as a solution to the inadequacy of traditional management accounting techniques that used volume based methods to allocate overheads to products. Activity based costing assigns the cost of each activity in an organization to all products and services according to the actual consumption of the activity resource by the product or service.
Image Credit: flickr.com/Meg and Rahul
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The most prominent of activity based costing limitations is its complex nature that prevents its widespread application. Activity based costing systems usually remain difficult to comprehend and costly to operate.
Activity based costing requires management to not only estimate the costs of each activities and identify and measure the cost drivers for such activities, but also update the same on a regular basis. Traditional management accounting uses a single cost-center approach, and implantation of activity based costing might require division of costs into multiple pools to represent the many activities. This takes away much of the organization’s resources such as management time and cost.
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A major limitation of activity based costing is that while it institutes a complex methodology to assign costs to activities, the system remains far from perfect. The major shortcomings include:
Some overhead costs such as the chief executive's salary remains impossible to divide and allocate on a per-product usage basis.
Not all productive activities need to add value to products. For instance, an employee taking part in a first aid awareness campaign or a fire safety drill indulges in a productive activity, but such activities do not add any value to the end product or service.
Most activity based costing methods assign such 'business sustaining' costs to products on a proportionate basis or based on assumptions, and this makes the system far from perfect.
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The Big Picture
A major ABC limitation is that activity based costing places too much attention to detail and control on processes. This causes a severe limitation in that it obscures the bigger picture by causing the organization to lose sight of strategic long term objectives in a quest for small or short term savings. For instance, activity based costing might identify one distribution channel as non-remunerative when such channeling might be placed to achieve strategic depth rather than profits in the first place.
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Confirmation to Standards
Activity based costing, while providing for better management control over the business process, does not conform to generally accepted accounting principles (GAAP). This means that firms following activity based costing need to duplicate their efforts by maintaining two cost systems and separate accounting books for internal use and external reports, filings, and statutory compliance.
Finally, activity based costing does not replace an existing job order or process cost system, but rather supplement the same.
The are many activity based costing limitations that lead to further research and result in the development of lean accounting methods such as Balanced Scorecards and Economic Value Added (EVA). Such methods take a new approach by eliminating cost allocations and focusing on thorough accounting, controls, and measurement systems, without the complex and costly methods of activity based costing, thereby doing away with the limitations.
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- Kaplan, Robert, S, & Anderson, Steven, R. Rethinking Activity Based Costing. Harvard Business School. Retrieved from http://hbswk.hbs.edu/item/4587.html on 4 November 2010.
- Ellis-Newman, Jennifer. Activity-Based Costing in User Services of an Academic Library. Retrieved from https://www.ideals.illinois.edu/bitstream/handle/2142/8473/librarytrendsv51i3f_opt.pdf?sequence=1 on 4 November 2010.