Disadvantages & Advantages of Activity Based Costing

No matter how big or small your business is, managing business costs is a top priority. Costs that overpass your revenue can break your business and prohibit your growth. So, you must be aware of your business budget and all your costs, prepare for them, and assess them regularly. 

Why do businesses need to keep track of all business costs? Ensuring they fit with their business budget is one reason. A bigger reason is to better inform how you price their products and services. The consequences of improper pricing for a business are severe. 

If your prices are too high, your customers might feel frustrated. That might lead them to seek your products from competitors. This would lengthen your sales cycle and reduce your revenue. If your prices are too low, your business won’t maximize its profit margins. You’ll also lose opportunities to experience meaningful growth.

But some businesses just have so many costs that it’s hard to keep track! And these costs aren’t always visible. You might not attribute your business’s everyday activities to consistent small costs. You might not think just how much money goes into each particular product you offer, besides raw materials and labour. There are many indirect costs that you incur with everything your business offers.

How can businesses get a handle on all these costs and turn indirect costs into direct costs? How can they ensure they price their products and services correctly? Activity-based costing is one way. 

Here’s What We’ll Cover:

What Is Activity-Based Costing?

How Does Activity-Based Costing Work?

Advantages and Disadvantages of Activity-based Costing

Key Takeaways

What Is Activity-Based Costing?

The concept of activity-based costing first appeared in 1971. George J. Staubus coined the term at the University of California – Berkeley’s Haas School of Business. Later, Robert S. Kaplan and William J. Bruns published an official definition of ABC at Harvard’s business school. 

The manufacturing industry first applied ABC as a costing method. But, the concept gained popularity and many other industries continue to use it today. 

In simple terms, activity-based costing helps you see how your products and services related to your overhead costs. Unlike traditional costing methods, it assigns the cost of each business activity to each product and service. 

Indirect costs might include overhead like utilities and salaries. Assigning those costs to products and services helps companies to become more aware of their indirect costs. And, it informs companies on more strategic pricing plans for their costing of services and products. 

How Does Activity-Based Costing Work?

To use the activity-based costing model, follow these easy steps:

1. List all actions or activities undertaken to create and offer a product or service.
2. Separate each activity into cost pools. For example: maintenance, manufacturing, research and development, and more. 
3. Find out what cost drivers affect each cost pool, like labour hours or machine hours.
4. Calculate the cost driver rate (Overhead in each cost pool / Total Cost Drivers)
5. Calculate overhead for a service or product by multiplying the number of cost drivers by the cost driver rate.

Complete these steps for each one of your products or services, and compare them! See which of your offerings are the most profitable and which ones incur you more losses. This will help you decide which products to maintain as high-volume products or to switch to low-volume products. 

Example of Activity-Based Costing

Let’s look at a hypothetical example of the activity-based costing system with the following attributes:

Company: Retail

Service: Personal Shopping Session

Overhead – $ Spent Per Year on Hydro: $20,000

Cost Driver – Labour Hours or Machine Hours Per Year: 1,000

Cost Driver Rate = Overhead Costs (Hydro, $20,000) / Cost Driver (Machine Hours or Labour Hours, 1,000)

Cost Driver Rate = $20

Overhead Costs for Personal Shopping = (Cost Driver Rate) (Hours using indirect cost per product)

Overhead Costs for a Personal Shopping Session = 20 (5)

Overhead for Personal Shopping Session = $100

Advantages and Disadvantages of Activity-based Costing

Using an activity-based costing method is one way to understand the costs associated with each product or service you offer. Let’s explore some advantages of activity-based costing as well as its disadvantages. 

4 Benefits of Using Activity-Based Costing (ABC) to Manage Costs

1. ABC Makes Indirect Costs Traceable

   Using the ABC model, you can attribute indirect costs like depreciation or utilities to certain activities. This helps you quantify the costs, as you see their relation to each service or product.  

2. ABC Informs Pricing Strategies

   ABC offers valuable insights to help companies better manage and plan their pricing strategies. Experts say that the planning edge offered by ABC can help companies find 10% in cost savings each year. Companies experience those savings when they learn to price their products properly. By properly, we mean profitably, with the insight of ABC. 

3. ABC Helps Pinpoint Activities that Don’t Add Value

   Since ABC entails finding every activity that goes into a product or service. If you notice many activities keeping your costs up, it forces you to reflect on how vital that activity is to your product. Cutting out activities and inefficient processes that don’t add value helps to save your business money. It also helps you rethink your business strategy and enhance some process improvements. 

4. ABC Helps Pinpoint Unprofitable Products

   As a business, you might notice that the true costs associated with a product or service are higher than the others. Perhaps a proper, lucrative profit from the price makes up for it. If not, perhaps you can raise the price or drop some activities or cost drivers. 

   Certain services and products can’t exist in their full capacity and quality without the activities necessary to offer them. You might increase the price, but it’s a fine line between profit and lost customers if you do that. In some cases, you might just have an unprofitable product that you should consider removing from your offerings. 

Disadvantages of Activity-Based Costing

1. Collecting and Analyzing Information Has Its Own Costs

   While trying to save costs through the activity-based costing model, you might actually achieve the opposite. You might incur extra costs in the time and labour it takes to collect and analyze the information needed for this model. 

2. Businesses Might Need A Lot of Time to Collect Data

   You can’t easily access the data you need to calculate activity costs. You’ll need to do some digging and use up precious labour or machine hours to find the necessary data. 

3. ABC Isn’t Always Effective

   Some businesses by nature have low overhead costs, like a writing agency for example. These types of businesses might find more efficiencies in using traditional costing methods than ABC. And in these cases, the costs incurred to collect and interpret data for activity-based costing aren’t worth the return. 

Key Takeaways

As small business owners, freelancers, small-to-medium enterprises, or anyone else involved in business, the goal is to reduce spending and improve profits. One way to lead you to that goal is through the activity-based costing model. With it, you can identify the true costs of your business activities and mitigate them. 

To take better control of your business, download FreshBooks. Our software is a direct path to better accounting without the accountant’s price tag. 

Want to learn more about small business practices and strategies? Make sure you check out our Resource Hub. There, you’ll find tons of helpful information about savings methods, income tax, and much more.

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