Abc Costing System

ABC vs Functional Based Costing

In the traditional cost system, a single unit-level basis is used to track indirect costs such as direct labor or machine hours used to manufacture the product (weygandt et al 2005). In this approach, the cost of overhead increases with increased volume of units produced. Such costing system would create inadequate cost information in today's global and technological environment as direct labor in manufacturing significant decreases while large amount of machinery usage increases (Rattanaphaphtham and Ussahawanitchakit 2010). This cost allocation would mislead managers in decision making on product price as the relationship between product and cost incurrence is not captured correctly (Qian and Ben-Arieh 2008).

The main problem a traditional costing system faced is undercosting and overcosting. As mentioned earlier, the system uses a single unit-level measure as an overall cost driver which tends to assign costs to products based on an arbitrary average basis. It does not meet the cause-and-effect criterion desired in cost allocation. Thus, products that require customization and more resources to build are not assigned its fair share of cost, resulting in undercosting. On the other hand products that are fairly easy to build and require fewer resources are assigned with higher costs which it should not bear, causing overcosting. Using these inaccurate cost information in pricing decisions may cause unintended predatory pricing or over pricing.

ABC has been accepted as more accurate in the costing and pricing of products than traditional cost accounting (Hilton et al. 2008). In ABC, cost is first allocated to all the activities performed to manufacture a product, and from there to the product based on how much each product uses the activities (Hilton et al 2008). In this way managers can have a clear picture of what cause costs and modify the activities to reduce cost of product in an effective manner.

Besides that, non-value added costs can be identified and minimise so that pricing can be lowered without sacrificing customer perceived value (Weygandt et al. 2005). For example, inventory storing and handling; transportation of raw materials or partly finished products; and redundancies in production-line configurations are few non value added costs that could be reduced.

In conclusion, activity based costing provides accurate, reliable and relevant cost information for managers to improve overall efficiency as unnecessary costs are identified and reduced. At the same time lower cost allows managers to make competitive price decisions effectively. However in companies that involve little indirect costs and accuracy of cost information is not crucial for the success of the company, using a traditional system might be much simpler and costs less than implementing a complex system that will not benefit the company significantly.