Question

The chief executive officer (CEO) of your company recently returned from a luncheon meeting

where activity-based costing was presented and discussed. Though her background is not in accounting, she has worked for the company for 15 years and is thoroughly familiar with its operations. Her impression of the presentation about ABC was that it was just another way of dividing up total overhead cost and that the total would still be the same “no matter how you sliced it.”

Required

Write a memorandum to the CEO, no more than one page, explaining how ABC is different from traditional volume-based costing methods. Also, identify its advantages and disadvantages vis-à-vis traditional methods. Be sure it is written to be understandable to someone who is not an accountant.

Short answer

Answer

ABC method is a system of allocating overheads based on activity and their driver.

Step-by-step solution

Difference between ABC and Traditional volume-based costing

Basis of difference	ABC Costing	Traditional Costing
1. Meaning	It is the method of allocating overhead based on different activities and their driver	It is the method of allocating overhead based on a single cost driver
2. Orientation	It is a process-driven method	It is a cost-driven method
3. Applicability	ABC method comparatively is complex and difficult to implement	The traditional method of allocation is an easy and simple method to adopt
4. Effectiveness	ABC method is the most effective method for allocation as it brings transparency and cost control	The traditional method is comparatively less effective as it does not bring a cost control element.
5. Scope	ABC costing can be used to allocate both manufacturing and non-manufacturing overheads.	The traditional method can be used to absorb only manufacturing overheads.

Advantages and disadvantages of ABC costing

Advantages of ABC Costing

1) Effective overhead cost control: one of the advantages of ABC costing is that it identifies activity and the benefit of process improvement. Thus this is the system that brings effective overhead cost control.

2) Better Decision: This method of cost allocation is helpful in taking more accurate and informed production and pricing decisions. This is so because the allocation is made based on more cost pools and activity rates than any other method.

3) More scope: ABC system has a wider scope for use like allocation of administrative or nonmanufacturing overheads etc.

Disadvantages of ABC Costing

1) Expensive method: In comparison to the traditional method, the ABC method is more expensive to implement in terms of collection and analysis of data,

2) Chances of cost distortion: Although the ABC system has scope for all overhead allocation, it still lacks some cost classification. Some drivers may not have a strong cause-effect relationship.

3) Complexity and uncertainty: As compared to the traditional method this system is more complex and there also lives some uncertainty in certain decision making.