There are several considerable differences between the traditional overhead allocation and ABC (activity-based costing) systems. With the traditional costing method, a company will have only one overhear rate, which will be calculated based on the direct labor or machine hours (Weygandt, Kimmel, & Kieso, 2018). In this case, the overhead will be calculated universally regardless of the activity. As opposed, the ABC costing method uses multiple activity pools, which will be calculated based on each of their metrics (Weygandt, Kimmel, & Kieso, 2018). Traditional costing is much easier to implement compared to the ABC system, but it is also not as accurate. In the long run, the ABC system proves a lot more effective as it results in better cost management.
There are many ways in which a company can benefit from implementing ACB costing. First of all, this method allocates overheads based on the actual consumption of resources, which makes all the expenses more transparent (Mahal & Hossain, 2015). Therefore, it becomes easier to detect and eliminate non-value-adding activities, and vice versa. By helping to spot better ways of allocating cost, the ABC method allows making smarter pricing decisions, and therefore increasing overall profitability.
As good as the ABC method may sound, it might not be the best decision for every company. It is a responsible move, which can affect lots of business processes. Therefore, the organization should carefully analyze its needs at the moment. There should be a trade-off between the costs of implementing ABC and its economic benefits (Mahal & Hossain, 2015). If the trade-off is not happening, it is better to stick to the existing system. Also, the ABC system is a lot more complicated, so if the accuracy of traditional overhead allocation is satisfactory and does not cause any profit loss for the company, there is no need to change it.
The overhead allocation is essential for most manufacturing environments as it directly impacts the profitability of a business. It is critical to have a complete picture of all the expenses to be able to allocate them responsibly. Allocating overhead has utility and it is particularly beneficial for making pricing decisions. If a company bases its pricing solely on direct production cost, they automatically cut down their profit. When indirect costs are clearly visible, a business can easily cover them with pricing.
Allocation of overhead is often problematic for an organization due to a lack of precision and accuracy in estimations. Since overhead costs are indirect expenses that do not influence the manufacturing process directly, it can be challenging to determine the exact amount of costs to allocate. That being said, indirect expenses are necessary for the smooth running of a business. The most typical problem that arises during overhead allocation is the inability to estimate the costs accurately. As a result, a company can make an incorrect assumption about the profitability of its product. If this is the case, then ABC costing can be an ideal solution to this problem.
By providing more accurate estimations, this method helps companies strike a balance between allocating too little or too much. ABC costing is much more complicated, but it is a sure way to obtain an accurate picture of all the expenses and ensure better cost management in the company. The existing problems will be solved, but it is also important to realize that the new system might bring new challenges, and get ready to deal with them.
References
Mahal, I., & Hossain, A. (2015). Activity-Based Costing (ABC) – An effective tool for better management. Research Journal of Finance and Accounting, 6(4), 66-72.
Weygandt, J., Kimmel, P., & Kieso, D. (2018). Managerial accounting, loose-leaf print companion: Tools for business decision-making. Hoboken, NJ: John Wiley & Sons.