It Is Argued That The Activity Based Costing Approach Produces More Accurate Product Cost Information. Critically Evaluate The Strengths And Weaknesses Of This Statement.

2296 words - 9 pages

Before the 1980s, majority of the companies were manufacturing units, producing a limited range of products, with material and direct labour being the paramount costs. Since overhead costs were low and information computing costs high, the companies were satisfied using traditional product costing methods. The emergence of the 1980s, brought with it intensive competition across the globe and growing importance of overheads while that of direct labour declined (Drury, C., pp 225). Also there were problems that were being faced with traditional cost systems. The use of traditional costing lead to a distortion of data as it allocated indirect manufacturing costs by using volume-related formulae. These formulae were actually based on direct labour or direct material and the percentage contributed by these costs towards the product or service was a relatively small amount. The information thus provided by these systems was inaccurate and lead to incompetent decisions being taken on account of matters such as capital investment and product policy. The information would also misdirect the management in terms of the financial situation of the company, this lead to decline in profit (Macintosh, N.B.).Therefore the changing corporate environment and problems with the traditional costing systems brought about a need for an alternative cost system that was both innovative and sophisticated. This alternative as suggested by Cooper and Kaplan (1988) was Activity Based Costing (ABC) based on the following theory (Harvard Business Review (1988)):"Virtually all of a company's activities exist to support the production and delivery of today's goods and services. They should therefore all be product costs."Further on they published a series of articles that explained the key ideas that supported ABC type systems. These articles lead to an appreciable amount of popularity and implementation of ABC by a number of companies, so much so that a survey of the companies in the UK by Innes and Mitchell (1991) stated that approximately 10% o the companies were in the process of or were already using ABC (Drury, C., pp 225)."Activity Based Management helps a company develop strategy, long-range plans and subsequent competitive cost advantage by focusing attention on activities". Activity Based Costing is used as a tool in Activity Based Management. Activity Based Costing follows a set of steps, which relate costs to activities and then to the products depending on the product's usage of the activities (Stickney, M and Weil, pp 153). The steps that ABC uses are firstly the identification of the cost object that has been chosen and the direct costs that are related to the product. Secondly the users then must select the bases of cost-allocation, which is to be used to allocate the indirect costs to the product. Further on the indirect costs that relate to each cost-allocation base must be identified. Third comes the calculation of the rate per unit of each cost-allocation...

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