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The benefits of activity-based costing in helping businesses understand costs and reducing expenditures is varied, because this costing method takes many costing factors into account. Unlike other costing methods, which normally cannot estimate production costs, activity-based costing offers more accurate estimates. Businesses typically have to compare an item's price and selling record to see if it is worth producing, and one of the benefits of activity-based costing is better analysis of both good and bad products. Overhead costs can be a major problem with some products, but this system better shows those costs and helps reduce overhead. Managers often can work better under this costing system, because they have more accurate information.
When traditional costing methods are used, they have ways of estimating product creation, but the metrics used are rarely accurate. This is because these methods typically only estimate the entire production cost and only take labor and other broad metrics into account. One of the benefits of activity-based costing is a more accurate product-creation cost. With this costing method, analysts can figure out the per-product cost and, thus, more realistic metrics are used for estimation.
After a product is created, it is sold, but businesses rarely continuously sell a product without it being profitable. To ensure they are not losing money, businesses analyze the product to see if they are making a profit. Another one of the benefits of activity-based costing is better analysis of a product to see if it is worth the expenditure to keep producing. This is because the activity-based costing method better analyzes the product’s price and uses more factors when determining profitability.
Before a product is created, businesses typically will analyze overhead costs to know if there is enough available money to make the product. As with the per-product price, activity-based costing is able to produce many factors that directly affect cost, such as production costs, labor hours and part requirements. The product is not being made yet, so businesses can analyze these factors and find ways to decrease them to limit the product’s overall price when production does starts.
With traditional costing methods, selling and production managers both work with inaccurate information, because these costing methods rarely accurately estimate the product’s price. This means managers may make devastating decisions, wrongly thinking they are not hurting the business. One of the benefits of activity-based costing is that managers usually receive better information, leading to better decisions.
As an ABC practitioner with twenty years experience implementing and maintaining activity-based costing systems, I want to make one thing very clear. There is a great, often irreparable, harm in a “peanut butter” spread approach to the allocation of overhead expenditures based on labor hours, staff count, or some other arbitrary driver. When determining product price and/or profitability, the back-office and overhead allocations are skewed, either favorably or unfavorably, to specific products and customers. And decisions based on this skewed methodology and its accompanying metrics may result in lost profits or the “unthinkable” – the collapse and bankruptcy of a once profitable entity. Activity-based costing offers an alternative to this approach.
As you clearly note, ABC aligns overhead with products or
customers proportionate to the services consumed by each. A product that uses half a factory’s space incurs half the facilities cost. A customer, who requires ongoing support, either by phone or in person, receives a larger share of the back-office costs than a client, who is generally self-sustaining. A product with ongoing quality defects and rework should never receive the same engineering cost assignments as an error-free production. Through activity-based costing assignments, these disparities are uncovered and specific products, customers, or channels bear the responsibility for consuming those services.
Let’s be clear. ABC does not in any way reduce costs. It is only management’s ability to understand and use ABC data that creates those cost reductions or resource re-deployments. Management has the authority to change product pricing, move offerings to different channels, or terminate customers. It is ABC that can provide the information necessary to make these strategic decisions.
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