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22.1 Explain Why and How Activity-Based Costing Is Used

Limitations of Traditional Costing​

Traditional costing systems (job order and process costing) often use a single overhead rate based on a single allocation base (like direct labor hours or direct labor cost). This can lead to cost distortions.

Problems with Traditional Costing:

  • Overcosting: Some products are assigned too much overhead
  • Undercosting: Some products are assigned too little overhead
  • Single Allocation Base: May not reflect actual cost drivers
  • Volume Bias: High-volume products may subsidize low-volume products
  • Inaccurate Profitability: May show unprofitable products as profitable

Example: Traditional Costing Problem​

Restaurant Example:

  • Total overhead: €30,000 per month
  • Total direct labor hours: 2,000 hours
  • Overhead rate: €30,000 ÷ 2,000 = €15 per direct labor hour

Menu Items:

  • Simple Dish: Takes 0.5 hours, uses simple equipment
  • Complex Dish: Takes 1.0 hour, uses specialized equipment, requires setup time

Traditional Costing:

  • Simple Dish overhead: 0.5 × €15 = €7.50
  • Complex Dish overhead: 1.0 × €15 = €15.00

Problem:

  • Complex dish uses more equipment, more setup time, more supervision
  • But overhead allocation doesn't reflect this
  • Complex dish may be undercosted
  • Simple dish may be overcosted

What Is Activity-Based Costing?​

Activity-based costing (ABC) is a costing method that:

  • Identifies activities that consume resources
  • Assigns costs to activities (cost pools)
  • Uses cost drivers to allocate activity costs to products/services
  • Provides more accurate product costs

Key Concept:

  • Activities cause costs, not products
  • Products consume activities
  • Allocate costs based on activity consumption

How ABC Works​

Step 1: Identify Activities

  • List all activities that consume resources
  • Examples: Setup, inspection, ordering, processing, packaging

Step 2: Assign Costs to Activities

  • Determine cost of each activity
  • Create cost pools for each activity

Step 3: Identify Cost Drivers

  • Determine what drives each activity's cost
  • Examples: Number of setups, number of inspections, number of orders

Step 4: Calculate Activity Rates

  • Activity rate = Activity cost ÷ Cost driver volume

Step 5: Allocate Costs to Products

  • Product cost = Sum of (Activity rate × Activity consumption for product)

Benefits of ABC​

Advantages:

  • More Accurate Costs: Better reflects actual cost consumption
  • Better Decisions: More accurate information for decisions
  • Cost Management: Identifies activities that drive costs
  • Profitability Analysis: More accurate product profitability
  • Pricing: Supports better pricing decisions

Disadvantages:

  • More Complex: Requires more analysis and tracking
  • More Expensive: Higher implementation and maintenance costs
  • Time-Consuming: Requires more time to implement
  • May Be Overkill: May not be worth it for simple businesses

When to Use ABC​

Use ABC When:

  • Overhead costs are significant
  • Products/services consume resources differently
  • Traditional costing shows cost distortions
  • Need accurate cost information for decisions
  • Multiple products/services with different characteristics

May Not Need ABC When:

  • Overhead is small relative to direct costs
  • Products are very similar
  • Simple cost structure
  • Cost of ABC exceeds benefits

Luxembourg Compliance Note​

In Luxembourg:

  • ABC is not required but can be valuable
  • Use for internal management decisions
  • May support better financial reporting
  • Consider cost vs. benefit
  • PCN accounts support ABC implementation
  • Can improve cost accuracy and profitability

Think It Through​

Why might traditional costing systems provide inaccurate product costs? What types of businesses would benefit most from activity-based costing?