Cost effectiveness


This report aims to evaluate and examine how useful activity based costing is to modern businesses.

Cost effectiveness is a key element of business competitiveness. (Goulden & Rawlings, 1997)

Costing plays a major role in managerial accounting and the cost information is required for the management to carry out management functions such as planning, directing and controlling. One of the most important decisions to be made is about the type of costing system that would be suitable for an organisation.

Activity based costing (ABC)

Activity based costing is a new costing technique that emerged during the late 1980’s, its founders were Professor Kaplan and Cooper. It was developed in manufacturing for a better allocation of overheads cost. It has been identified as the most suitable method for modern manufacturing environments.

Activity based costing is a costing system that identifies activities in an organisation and assigns the cost of each activity resource to all products and services according to the number of transactions involved in the process of providing a product or service. It’s a technique which assists businesses to collect information about their operating costs and allow them to come to a decision on which products/services and resources are increasing their profitability and which are contributing to losses. ABC systems tend to be sophisticated, i.e. they are expensive to operate and which minimises the cost of errors and will have a high level of accuracy.

ABC is one of the recent management accounting technique which is recognized in various modern organisations as opposed to traditional costing method. Traditional costing systems rely extensively on arbitrary cost allocations. Traditional system tends to be simplistic which means they are inexpensive to operate and an accurate calculation of product profitability is not possible.

Stages and flow of costs in activity based costing

There are two main stages in ABC:

1. Tracing cost to activities

2. Tracing activities to products

The different steps in the two stages of ABC are:

1. Identifying the major activities

2. Factory overhead costs of the activities are determined and classified into homogeneous cost pools

3. The factors that influence the cost of a particular activity should be identified, they are known as cost drivers

Activities and relevant cost drivers

Activities drive costs; costs are allocated based on appropriate cost drivers.

Examples of activities and the relevant cost drivers.

Activities Cost drivers

1. Set-up costs 1. Number of set-ups

2. Purchasing materials 2. Number of purchase orders

3. Packing number of packing orders

4. Computer processing number of computer transactions

5. Quality control costs number of quality inspections

6. Requisitions costs from warehouse number of requisitions made

Classification of activities / nit of product activity hierarchy

Activities are classified into four. They are:

1. Unit level activities – are performed each time a unit of product/service is produced. They consume resources in proportion to the number of units of production and sales volume.

E.g. energy used in production equipment, equipment depreciation and machinery repairs and maintenance.

2. Batch level activities – are performed each time a batch of product is produced. The cost of batch level activities varies with the number of batches made.

3. Product level activities – cost of an activity required to support a specific type of product.

e.g. design costs and engineering costs to change product designs.

4. Facility level activity – the cost of an activity that support the organisation as a whole and cannot be traced to any product or service.

Advantages of activity based costing

Activity based costing is better alternative than traditional methods for cost determination and analysis.

It’s flexible and easy to discover where high (and low) costs are being incurred and helps to allocate more resources on profitable products, departments and activities.

Utilises unit cost rather than just total cost

Improves accuracy (it gives accurate costing of all activities to be obtained throughout an organisation

It helps to control the costs at an individual level and on a departmental level

Helps with future product planning i.e before product or service is launched, the cost of all activities associated can be determined accurately, therefore this helps with determining pricing and any associated expenditure.

Most kinds of activity – from industrial process to business operations to service delivery can be used to access by ABC.

Disadvantages of activity based costing

Companies that implement ABC run the risk of more time consuming, effort and even money on gathering and going over the data that is collected

Using ABC in the short run decisions may sometimes prove costly in the long run.

In a service environment, the tracing of costs to service delivery may result in too many cost drivers being identified than is feasible to implement.

There may be difficulties in determining the most appropriate cost drivers

Difference between activity based costing and traditional costing

Cost pools – ABC systems accumulate costs into activity cost pools. The costs in each cost pool is caused by the a single factor-the cost driver, whereas traditional costing system accumulate costs into departmental cost pools and the costs in each cost pool are heterogeneous and are not caused by a single factor.

Allocation bases – ABC allocate costs to products/services and other cost objects from the activity cost pools using allocation bases corresponding to cost drivers of activity. Traditional method allocate costs to products using the volume based allocation bases (units, direct labour input, machine hours).

Hierarchy of costs -

Cost of objects

Decision support

Cost control

Cost –abc- expensive to implement and maintain

Traditional- inexpensive to implement and maintain



Success and failures of activity based costing

Certain factors are necessary to help ABC succeed in an organisation. They are:

Interdependent environment-



Critical timing-

Coordination and integration-

Incentive alignment-

On the other hand companies receive results from their new costing system but either wouldn’t or couldn’t implement them. Organisations are simply resistant to change.

Difficulties with implementation include:

Too many or too few identified activities and cost drivers

Overly complex system design

Reciprocal cost allocation

Lack of technical expertise in the identification and analysis of activities

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