The Reality of ABC
Despite the limitations of ABC, many companies utilize the method. A quick internet search will reveal millions of references to the approach, including various management consultant groups praising its merits. As you might suspect, many important business decisions about the fate of a product are based on assessment of profitability, and profitability boils down to comparing sales price to cost. Because the sales price is pretty well set, the "decision" about how to determine a product's cost is obviously quite significant in assessing the bottom-line profitability for an individual product or service.
Now, for a single-product company with fairly stable inventory levels, this is much to do about nothing. Traditional and ABC methods will get to about the same end point. But, for multi-product/service firms, the arbitrary allocation of costs can pretty much "make or break" the perceived profitability of each product or service. As companies have grown larger and more diverse in output, there has been an accompanying concern about how costing occurs. Arguably, product diversification has been a major contributing factor into the management accountant's pursuit of alternative costing devices like ABC.
Another driver of ABC-type approaches has been the advent of computer technology. Before modern information systems, it was very expensive to manipulate data. Most firms were perfectly content to live with simple approaches that allocated factory overhead on a single basis. The ease with which data can be managed under a sophisticated information system greatly reduces the cost and error rate associated with ABC. It is not surprising that the method's popularity is inversely related to data processing costs.
A Closer Look at ABC Concepts
If you think about traditional costing methods, the "cost object" is usually an end product or service. Very simply, prime costs are traced to output while factory overhead is allocated to output. Nonfactory costs do not get assigned to a product:
Compare this traditional logic to ABC, and you will see a reversal of the thought process. With ABC, the "cost objects" are broadened to include not only products/services, but other objects like customers, markets, and so on. These "cost objects" are seen as consuming "activities." The "activity driver" is the event that causes consumption of an activity. For instance, each customer may receive a catalog, whether they order or not during a period. Preparation and distribution of the catalog is the "activity" that is being driven by the number of customers. Continuing, activities necessarily consume resources. Thus, preparation of a catalog will require labor, printing, office space, etc. Thus, activities drive the need for resources and are said to be "resource drivers." The following graphic reveals the conceptual notion of ABC, which is quite different and much more involved than the traditional costing approaches. In reviewing the graphic, notice that costs that are directly traced to a cost object need not be "routed" through an activity:
One last item before moving on. The preceding graphic is simplistic. A business might have dozens of cost objects, hundreds of activities, and numerous resource pools to evaluate. A diagram of the interconnectivity can look like a printed circuit board design with multiple cost objects feeding off of many shared activities that in turn pull on various resources. At some point, the cost to implement and monitor ABC can exceed the benefit. Never forget the primary purpose is to allow management to get a better feel for product costs; some degree of arbitrariness will inevitability be accepted to avoid excessive complication.