Advantages of Activity-Based Systems
Activity-Based Systems determine the real cost of overhead before assigning the costs to such activities. Therefore, a company allocates costs to those units that require the activity. The approach appreciates the fact that at any point, the company’s activities will occasion cost, which will vary with production levels. Therefore, the costs should be assigned to the products that require such activities to arrive at a more accurate measure. The distinguishing feature of Activity Based Costing is that it links the output of the manufacturing entity to the cost of all activities involved in production. Value-added activities could be determined using this approach. The manufacturing entity can proceed to eliminate activities, which are not adding value to the product. This will improve the manufacturing system’s performance.
With activity-based costing, you take all activities required to produce an item into consideration. This can include R&D, testing, purchasing, set up of machines, packaging, and cleaning and maintenance. These are all necessary to produce an item; however, they may not be taken into consideration when using the traditional method of costing (Shaw 130).
Disadvantages of Activity-Based Systems
Management may resist activity-based costing methods because of the failure of the implementation team to involve all departments in the process. The non-involvement of other departments in the implementation is likely to lead to resistance. The accountants’ attempts to implement ABC on their own will, in most cases, lead to resistance due to ignorance of the new system and the lack of input from the other departments that have detailed knowledge of the operations of the firm (Shaw 98).
The implementations of the ABC system may also encounter resistance since it results in a shift in the measures used by management in their decision-making activities. Hence, management must learn to adopt new methods while determining variables, which they use while making manufacturing decisions. Senior managers will also be required to use the information afforded by ABC to evaluate the performance of middle-level managers. Managers are likely to resist this new transparency. Another cause of resistance is that ABC introduces a certain level of rigidity in decision-making. Cost estimation requires leeway. Hence, it is more of an art than a science. Decision-making involves other variables apart from cost such as time and quality (The Economist par 1).
Where ABC may be used effectively
Activity-Based Costing leads to the generation of activity rates. Activity rates are vital to management since they enable management to determine with great accuracy the cost involved in production. The management can quickly estimate the cost of producing at a certain level using activity rates. Activity rates are also important in determining the efficiency of production. The management can use these rates to determine which activities add the most value to the production process. The production process can thus be improved by eliminating non-value-add activities. This allows for a flexible process, which companies can modify to reduce the negative effects of some activities. Activity rates also offer management information, which greatly improves their decision-making ability. Hence, ABC can be instrumental to managers at a manufacturing plant, for example, car production (Kaplan & Anderson 56).
Kaplan, Richard & Anderson Simon. Time-Driven Activity Based Costing. Harvard: Harvard Business School Press, 2007. Print.
Shaw, Walter. Managerial Accounting. New York: McGraw Irwin, 2005. Print.
The Economist 2012. Activity-Based Costing. Web.