Many factors compel companies to use activity-based costing. There are different signs that show that companies can be able to implement ABC. Most of the organizations that use ABC have a high probability of cost distortions. When companies use one activity to recover overhead, there is a very high probability that there will be over or under-costing of some products.
Cost-distortion can affect critical decisions in a company such as pricing of goods and services which will have a direct impact on profitability (Anderson and Young 32). When a company implements ABC, it can be able to assess the profitability potential of its customers to determine whether clients are profitable or not (Epstein and Allain 142). However, if a company has a low potential for cost distortion, applying activity-based costing may not be the best cost-saving strategy.
When a company has useful information on cost, it can be able to implement activity-based costing. ABC can only be applied when a company has adequate information about cost behavior. However, firms that sell products and services that are dictated by market price cannot be able to implement activity-based costing because they do not know how the market price will change. Activity-based costing can be effective for firms that deal with multiple products. Such companies can be able to negotiate with suppliers in order to reduce costs. Adequate cost information is another sign that a firm can be able to implement the ABC model. When a company lacks a well-established information system, it cannot be able to implement activity-based costing (Cokins 24). Activity-based costing requires extremely detailed information that cannot be acquired if the organization lacks a well-established information system.
Managers should be concerned about the broader average product costs because it will affect the price of goods and services. The average cost has a direct impact on the total cost attributed to each product and service. Therefore, it is critical for managers to ensure the data is accurate in order to safeguard the prices of its products and services.
To implement ABC, some steps must be followed including activity identification, activity analysis, and assignment of costs (Baker 12). Before implementing activity-based costing, all the activities in the company should be identified and classified into cost pools. These cost pools include fractionally assigned costs for individual products. Secondly, an accountant should establish clearly the processes that support a product (activity analysis). Finally, after the costs are identified and assigned to individual products, managers should assign them to each activity using an established activity rate (Goektuerk 46).
There are four hierarchies used to classify costs in activity-based costing including batch-level costs, product-sustaining costs, facilitating-sustaining costs and output-unit sustaining costs. Batch-level costs include set-up costs and costs incurred when moving materials within the organization. Product-sustaining costs include motor vehicle design costs and spare part administration costs. Facilitating-sustaining costs include employee training costs, and motor vehicle depreciation (Toit 153).
Many factors affect the successful implementation of the ABC model in an organization. For instance, ABC is affected by the failure of managers to estimate costs of activities in the cost pools. If managers cannot be able to identify and measure cost drivers, the company will not be able to implement ABC effectively. Activity-based costing requires managers to identify cost drivers to calculate the costs which will be assigned to each product. If they cannot be able to determine the cost drivers, it would be impossible to implement the model.
Many opportunities can arise when a company implements activity-based costing. For example, ABC helps enterprises in the automobile industry to reduce costs and improve processes. GM and Ford have benefited from using ABC through the elimination of non-value added activities. This has enabled the systems and processes in both companies to work efficiently (Chapman and Shields 667).
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Chapman, Christopher S., and Michael D. Shields. Handbook of management accounting research. Amsterdam Boston: Elsevier, 2007. Print.
Cokins, Gary. Activity-based cost management: an executive’s guide. New York: Wiley, 2001. Print.
Epstein, Marc J., and Élodie Allain. Advances in management accounting. Bingley, England: Emerald, 2014. Print.
Goektuerk, Hakan. Activity-Based Costing (ABC) – advantages and disadvantages: how ABC can be applied to institutions of higher education. Norderstedt, Germany: GRIN Verlag, 2005. Print.
Toit, Elda. Cost and management accounting: fresh perspectives. Cape Town: Pearson/Prentice Hall South Africa, 2007. Print.