Question

Explain how ABC (Activity Based Costing) give an accurate evaluation of management performance in comparison to traditional costing method

Answer 1

Activity Based costing is a method of Costing which involves allocation of overheads based on the activities consumed by the products and services. The traditional method of overheads allocation involves calculating predetermined overhead rate based on direct labor hour or machine hours and then allocating the cost to the products based on the direct labor or machine used for the product.

The traditional method of Cost allocation had disadvantages since cost allocation was not linked to the actual cost drivers of the product/service. For example, A product consuming less labor hours may get higher cost allocated due to the overall predetermined rate being higher. Hence the allocation is arbitrary and may not reflect the actual resources consumed by the product. To overcome these disadvantages Activity Based Costing is an improved way of allocating overheads based on activities consumed by each product/service. ABC Costing involves

• Identification of activities required for products/services
• Accumulating Cost in Activity cost pools
• Identify the cost driver for each activity
• Calculation of cost driver rate for each activity
• Allocation of cost to product based on activities consumed

Activity Based costing gives strategic advantage to an organisation when implemented. It helps in gaining superior cost advantage over its competitors. It helps management in various ways to improve its performance. Some of the benefits are explained below:

• It helps in accurate Product costing which is needed for new product launches, evaluating product line profitability and taking decisions. Traditional method of costing may lead to wrong decisions and high profitable products may be discontinued without actually understanding the cost drivers involved in it.
• It helps in Cost management through cost control and cost reduction. Since activities are cost drivers of the cost ABC method gives an insight into which activities are driving cost and which should be controlled to gain cost advantage
• ABC Costing helps management in taking reliable and timely decisions and helps improving the performance of the organisation
• It helps in identification of non value adding inefficient activities which can be eliminated and bring efficiency in the process
• ABC Costing helps in setting budgeting targets for the division and holds accountable for the activities within control.

Overall ABC method of Costing helps in accurate evaluation of management performance to gain strategic advantage compared to traditional costing method