Activity Based Costing

Activity based costing (ABC) is a costing model that aims to allocate costs to products and services more accurately. This model attempts to allocate costs depending on the actual activities that cause overheads to be incurred. Traditional models used simplistic approaches such as, use of machine hours, to allocate overheads. ABC seeks to identify key activities in an organization and allocates costs and resources depending on those activities (Ken, 2011).

This model is a valuable management tool; it aids in the decision making process. Managers have to decide about the portfolio held by the organization as well as their products and services. ABC helps one to identify the products and services that are no longer financially viable, as well as those that are overpriced. With this information, a manager can eliminate unprofitable products/services and competitively price overpriced products. ABC has also been useful in business process reengineering. It helps the management to identify processes or services that are ineffective and do not add value to the company's portfolio (Robert, 2004). This helps an organization to concentrate on those processes and services that add the greatest value to the organization.

Activity based costing concept was first developed during 1970's and 1980's. This model was seen as an important tool as technological advancement had led to the change in cost structure of many organizations. It was adopted by many organizations as it responded well to the challenge of changes in the cost structure in most of the manufacturing firms. Technological advancements and production efficiency drastically reduced the proportion of direct costs while increasing the proportion of indirect costs. This called for a more accurate allocation of the indirect costs since they had become more and more significant. The original concept of ABC was seen as suited for the production part of the value chain. However, these days the model is used all around the organization. The model may be used in the apportionment of costs related to research and development, production, sales and marketing, distribution and other area (Lana & Fei, 2011, pp 7-11).

Many companies that had enthusiastically embraced the use of the ABC model in 1980s ceased to use it in the late 1990s. Most of the managers felt that application of ABC led to a more accurate and reliable cost estimation. Despite the supremacy of activity based costing, the model is complex, and the data required for the model is expensive to obtain (Ken, 2010, pp. 1-5). The implementation of activity base costing system requires strong commitment from the top management of the company. From the activity base costing system a company can develop this model to produce two sets of cost estimates; one for internal management decisions and the other for external reporting purposes. This maintenance of two costing processes is expensive and cumbersome to maintain. The interpretation of the data used in this model may be misleading as it is prone to misinterpretation particularly by new users. It is crucial that the management of an organization scrutinizes information derived ...