Activity-based costing is a method used in large organizations to allocate costs to services and products. Activity-based costing is used as an alternative for traditional cost management and it addresses problems associated with traditional cost management. Organizations use activity-based costing in control and planning. The use of activity-based costing helps to avoid making decisions with the use of inaccurate data.
The organization used in the explanation of activity-based costing is a higher learning institution, which is a large university. The nature of a university is to use complex accounting systems, and most universities base their accounting systems on fund accounting (Saldarini, 2000). The main aim of the accounting system in universities is not to form the basis of decision-making for the administration, but it focuses on satisfying donor and legal stipulations. The importance of activity-based costing in universities is that it provides the consumers, legislators, administrators, and voters with important information critical in decision-making. The information provided through activity-based cost accounting is simple to understand for the users.
All organizations, including universities, have limited resources and they have competitors; therefore, the need to allocate the scarce resources in an efficient manner is paramount. The use of both direct and indirect costs in universities depends on the structure of the institution and the cost system in use. The finance department assigns costs to every product in the institution. It is possible for the universities to know the cost of each product based on the usage. Assigning costs for the products in the university helps the management to point out areas of concern through the finance department. The accounting department uses an activity-based costing system to allocate costs to different services and products. The importance of activity-based costing to a university is that different departments are easy to manage. The cost of different products in the university varies from one product to another and that defines the importance of activity-based cost.
Service in the university that uses activity-based costing is the allocation of indirect cost to the universities, which depends on different factors such as the number of teaching hours in a course and the number of students. As stated by Alabbadi and Areiqat, (2010), a course in this case is treated as a product or service and allocation of cost to specific products depends on the number of activities (p.251). One of the activities in activity-based costing is charges paid by students in a given course. The appropriate cost driver for the activity is product level drivers. Products, regardless of the number of units used, trigger the product driver. In universities, the number of hours taught in a course attracts more cost to the expense of the university and the students in that course. Charging people based on the cost of their courses in the university forms the basis of an activity-based costing system.
One of the strengths associated with an activity-based costing system is that it provides accurate costing of services and products. As a result, a university is able to allocate direct costs and indirect costs to its products and services. According to Maluso (2010), activity-based costing provides a better understanding of overhead to the finance department in the university, which may help in implementing ways that reduce overall cost. activity-based costing is easier to understand for everyone interested in learning. Despite its strengths, activity-based costing has a number of weaknesses associated with it. One of such weaknesses includes the high cost required in its implementation and maintenance (Ayvaz, & Pehlivanli, 2011, p.149). The processes involved in its implementation include a collection of data, checking and entering the data into the system. The data used in activity-based costing can be easily misinterpreted, posing the need for proper care in making decisions using the data.
The major difference between an activity-based costing system and traditional costing accounting is that activity-based costing consumes activities and traditional cost accounting consumes resources. activity-based costing makes use of drivers at different levels, while traditional cost accounting utilizes volume-related allocation. Both systems contain different orientations, where traditional cost accounting is structure-oriented while activity-based costing is process-oriented (Benninger, 1949, p. 387). Fixed cost is not included in the product because it leads to poor internal decision-making. activity-based costing does not include fixed cost but includes variable and overhead costs. Fixed cost does not change over a long time and it cannot form the basis of decision-making.
It is easier to allocate costs in services and products for managers who use activity-based costing than for managers who use traditional cost accounting. activity-based costing helps in saving costs by identifying the activities responsible for different costs at specified times. The identified cost in activities passes to the users when the products use the activity. Finally, activity-based costing benefits outweigh the merits of traditional cost accounting by a great margin in terms of efficiency and costs involved in utilizing the two processes.
Alabbadi, H. M., & Areiqat, A. (2010). The Systematic Relationship between the Activity Based Management (ABM) and the activity-based costing (ABC). Interdisciplinary Journal of Contemporary Research in Business, 2(2), 249-253.
Ayvaz, E., & Pehlivanlı, D. (2011). The Use of Time Driven activity-based Costing and Analytic Hierarchy Process Method in the Balanced Scorecard Implementation. International Journal of Business & Management, 6(3), 147-150.
Benninger, L. J. (1949). The traditional vs. the cost accounting concept of cost. Accounting Review, 24(4), 387.
Maluso, N. (2001). activity-based costing (ABC): What is it and how can reengineering Teams use it. Web.
Saldarini, K. (2000). Scholars tout the benefits of activity-based costing. Web.