The Disadvantages & Advantages of Activity-Based Costing

You may believe that you have the actual cost of production for your products, but if you're not using activity-based costing (ABC) methods, you probably don't have the correct information and could be making the decisions based on faulty information.


Activity-based costing is a method of identifying a company's indirect cost activities and assigning these costs to the products or jobs that use these activities.

What Is Activity-Based Costing?

Absorption-costing, or full costing, has for years been the most common method of allocating manufacturing overhead. This approach takes the full amount of manufacturing overhead and spreads it equally across the production volume of all products. It does not consider that certain products may be responsible for more or fewer costs from specific activities. Activity-based costing, also known as ABC, deals with this problem.

Activity-Based Costing vs. Full Costing

Trying to explain the application of ABC is easier with an example of its application. Take a look at the production figures for the Hasty Rabbit Corporation. Hasty Rabbit makes two models of sneakers: Swifty Feet and Blazing Hare. The relevant figures for the two styles are:

Swifty Feet

  • Production volume: 19,000 pairs per year
  • Unit cost of direct materials and labor: $45

Blazing Hare

  • Production volume: 11,000 pairs per year
  • Unit cost of direct materials and labor: $55

Manufacturing Overhead

  • Total manufacturing overhead costs: $300,000
  • Factory supervisor salaries: $80,000
  • Full-costing allocation of manufacturing overhead: $300,000 ÷ (19,000 + 11,000) pairs = $10 per pair of sneakers

When this allocation of $10 per pair is applied across the board to both styles, the total production cost of each is:

  • Swifty Feet total cost of production: $45 + $10 = $55 per pair of sneakers
  • Blazing Hare total cost of production: $55 + $10 = $65 per pair of sneakers

However, upon further analysis, the company's accountants discover that the production machinery of Blazing Hare sneakers is more complex and requires more attention from the factory supervisors. The accountants conclude that the $80,000 salaries of the supervisor should be allocated with $30,000 to Swifty Feet and $50,000 to Blazing Hare. This leaves the remaining $220,000 of manufacturing overhead to be applied to total production volume: $220,000 ÷ 30,000 = $7.33.

The revised unit cost of production using the ABC method is now as follows:

Swifty Feet

  • Allocation of factory supervisors: $30,000 ÷ 19,000 = $1.58 per pair of sneakers
  • Unit cost of manufacturing overhead: $7.33 manufacturing overhead + $1.58 supervisors = $8.91
  • Total unit cost of production: $45 + $8.91 = $53.91

Blazing Hare

  • Allocation of factory supervisors: $50,000 ÷ 11,000 = $4.55
  • Unit cost of manufacturing overhead: $7.33 manufacturing overhead + $4.55 supervisors = $11.88
  • Total unit cost of production: $55 + $11.88 = $66.88

The ABC method reveals realistic costs of production for each model. The ABC analysis shows that the total cost of production for Swifty Feet is actually $53.91 per pair, not $55.00 as originally calculated. The Blazing Hare costs more at $66.88 instead of the previous $65. These differences in costs of production have implications for profit planning, production scheduling and spending for marketing campaigns.

Advantages of Activity-Based Costing

  • Provides realistic costs of manufacturing for specific products
  • Allocates manufacturing overhead more accurately to products and processes that use the activity
  • Identifies inefficient processes and target for improvements
  • Determines product profit margins more precisely
  • Discovers which processes have unnecessary and wasted costs
  • Offers better understanding and justification of costs in manufacturing overhead

Disadvantages of Activity-Based Costing

  • Collection and preparation of data is time-consuming
  • Costs more to accumulate and analyze information
  • Source data isn't always readily available from normal accounting reports
  • Reports from ABC don't always conform to generally accepted accounting principles and can't be used for external reporting
  • Data produced by ABC may conflict with managerial performance standards previously established from traditional costing methods
  • May not be as useful for companies where overhead is small in proportion to total operating costs

ABC produces more accurate costing of products by essentially converting broad indirect costs into direct costs of production. It determines the costs of the various sources of indirect costs and allocates these expenses to the specific activities that use them.

Setting up an ABC system is time-consuming and expensive to maintain, but it provides management with valuable information that can be used to improve the efficiency of processes and increase product profit margins.