Advantages and limitations of ABC Costing

Antonio Franco Coaguila Gonzales

Every company in the world has as objectives the growth, the survival and the

obtaining of revenues and utilities; thus, to achieve them managers must make an adequate

distribution and allocation of their resources, human and financial, based largely on cost

information. In fact; when making decision, planning or even controlling the cost analysis is

essential, therefore costing systems takes importance within the companies. Formerly, costing

systems were limited to accumulate data for costing the final products made, this led to the

error in the companies since it was not accurate. However, the development of the industries,

given the technological advances and the globalization have made operations much more

complex than before and therefore companies have realized the importance of having a good

costing system. This statement is affirmed as according to Kaplan (1998) “many companies

now recognize that their cost systems are inadequate for today’s powerful competition”.

Every day, in the manufacturing companies, large sums of money are disbursed by

labor, electricity, raw materials, fuels and others, to carry out activities of producing, selling

and managing (Sinisterra, 1997), and the big problem arises when identifying and allocating

these costs, that is why the traditional costing methods are criticized because they do no

allocate accurately the products’ costs (Sanchez, 2013). At the present time, for sure lots of

companies in Peru have this problem, especially when working with indirect costs; and given

this problem, the ABC costing arises as a method of more realistic and accurate cost

allocation and thereby becoming the solution. That is why this essay will explain the

importance of ABC costing in companies; and on this purpose, first it will be explained

which are the production cost elements, next a focus on indirect manufacturing costs; then the

difference between the traditional costing and ABC costing, next which are the advantages

and limitations of ABC costing and finally the conclusions.

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The events that have occurred in recent years, like the economic crisis in 2008, not

only affected the United States of America but to the whole world; and it has created in

companies the need to adequately cost their products so that the can improve profitability

through the reduction of costs without increasing sales, therefore making their processes

more efficient and adequately identifying the consumption of resources of each product

manufactured (Cuevas, Chavez, Castillo, Caicedo & Solarte, 2004). Taking into account the

explained before is necessary to understand which are the fundamental elements that conform

a product, and they are the direct materials, direct labor and indirect manufacturing costs

(Isidro, 2014). The first two, by general rule, are of direct allocation; however, the third one

due to its nature requires additional procedures to achieve an adequate distribution so that

proportionally affects the product that consumes it without overcosting any other. In this way,

with the appropriate costs per unit, management would have the control over the product

costs and can make the right decisions to improve its business management (Isidro, 2011).

Given that the indirect manufacturing costs are the most difficult to interpret and

allocate, it is very important to analyze them. They are a set of costs that intervene in the

production process and are different from direct materials or direct labor. Indirect

manufacturing costs include indirect material, indirect labor, factory supplies and factory

consumptions (Giménez, Kaplan, Mallo & Meljem, 2001). The first, indirect materials refers

to all material that is an integral part of the product but its value is not representative with

respect to the cost per unit. Indirect labor are the salaries and other expenses related to the

workers whose activity is related to the production process and those considered direct labor

(production workers) for their non-productive work. Factory supplies refers to all kind of

materials consumed by the production plan, like stationery, soaps, lubricating oils, among

others. Finally, factory consumptions are all those costs that refers to various services such as
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mobile phone, public services and maintenance, as long as they are directly related to the

manufacturing plant (Isidro, 2009).

Continuing with the topic, we must differentiate the traditional costing system with

the ABC costing system. The first one considers that direct labor and direct materials are the

predominant factors of production, so under this costing approach, the indirect manufacturing

costs are assigned to the products using a rate, which for its calculation considers a measure

of production (Business Encyclopedia, 2017b). The criteria used in this costing model are the

measures related to volume, like labor, as the only element to allocate the products’ costs;

also, it is based on the units produced to calculate the indirect costs designation rates; so, in

other words, it uses general bases, as units produced or machine hours, without taking into

account the cause-effect relationship (Arias, Portilla & Fernández, 2010). On the other hand,

in the ABC costing the indirect manufacturing costs are allocated to the activities that

consume the resources, to later allocate these costs to the products in proportion to the

consumption of them from the activities, for which a cost-drivers must be established. Then,

the activities will constitute a core of accumulation of resources absorbed in the productive

process, capable of being assigned to the products (Business Encyclopedia, 2017a). In other

words, it uses the hierarchy of activities as a basis to perform the cost allocation and also uses

cost generators that are or are not related to the volume. In summary, the main difference

between the traditional cost system and the ABC cost system is that the first one is used

widely in companies that have a functional organizational structure and treats all fixed and

direct costs as if they were variables; and the ABC cost system can be used in any

organizational structure of a company and allows a detailed monitoring of the flow of

activities, in the organization by creating links between activities and cost objects (Gerencie,

n.d.). That is why ABC cost system when compared to the traditional costing system is much
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better in terms of efficiency and precision, since a more realistic and accurate cost is

obtained. To better understand these concepts, table 1 shows a random example as follows.

Table 1

Example of difference between traditional Costing and ABC Costing

Traditional Costing ABC Costing

Indirect Costs Amount Indirect Costs Amount
Organize fairs and
Wages and benefits S/ 5,750 S/ 3,320
exhibitions
Prepare advertising
Selling expenses S/ 1,320 S/ 2,234
campaigns
Depreciations S/ 1,100 Process claims S/ 1,210
Other supplies S/ 380 Visit Clients S/ 1,010
Maintenance S/ 265 Carry out Training S/ 850
Administration Prepare events for
S/ 30 S/ 221
Expenses clients
TOTAL S/ 8,845 TOTAL S/ 8,845

As it can be seen, traditional costing is very general in terms of cost and is difficult to figure

out exactly where the costs are o related to which process, while ABC costing shows a better

distribution and allocation of costs that allow to better understand where are the costs and

therefore facilitates decision-making processes to the managers. For example, to understand

better, if you were a manager and you ask for the indirect costs information and you receive it

with traditional costing system you would not know if, for example, “other supplies” refers to

buying folders, pens or papers for the administrative offices or for a training. On the other

hand, if you receive the information with ABC costing system, you would have more clear

information on where or which event you incurred on the cost, so it is going to be easier to

make decisions.

Having understood the main differences between traditional costing system and ABC

costing system, an also by stating that the latter is better; it is necessary to explain which are

its advantages and limitations. According to Smith (1995) the advantages to implement the

ABC system are various, in which stand out: better knowledge of the cost generating

activities to improve control over these costs; organizations with multiple products can
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achieve a totally different but more efficient arrangement of the costs of their products;

facilitates management measures, in addition to measures to assess production costs; and

increases the credibility and usefulness of cost information in the decision-making process

and makes it possible to compare operations between departments and divisions within the

company. On the other hand, for Amat and Soldevilla (1997) the main advantages are: better

identification of customers, products, services and other unprofitable cost objectives;

applicability to all types of production or service companies; easiness to calculate more

precisely the costs; and facility to be used for budget control (Activity Based Budgeting). In

contrast, Franco (1995) argues that the advantages are: better control and cost reduction

through the elimination of activities that do not add value; utility in the planning stage,

because it provides information that serves as a guide for several strategic decisions such as

pricing; and a better allocation of the indirect costs to cost objectives. As seen there is a wide

number of advantages compared with the traditional costing system.

After analyzing the advantages, is necessary to explain which are the limitations of

ABC costing system. At first, according to Kaplan and Anderson (2004) difficulties on ABC

costing “lie in the way people traditionally construct ABC models”, that is because it looks

like to be the better way to manage a company’s resources, but the reality is that many

managers have given up to apply it because of the fear of not achieving the goal or even

because of the discomfort of their employees, as Ness an Cucuzza (1995) affirms “employee

resistance is the single biggest obstacle to implementing ABC”. The first limitation is that

ABC costing is a system based on historic costs (Smith, 1995), therefore in some

circumstances its usefulness is doubtful given the fact that there can be some future costs that

cover much more importance. The second one, according to Amat and Soldevilla (1997) is

that assignment of costs can be increased arbitrarily, because costs are incurred at the process

and activity level and not at the product level. The third one, refers that the difficulty and
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high cost of applying ABC costing system on large scale companies as they have a wide

number of departments, plants or location and therefore many activities; as an example,

Kaplan and Anderson (2004) set the following:

In one large bank’s brokerage operation, the ABC data-gathering process

required 70,000 employees at more than 100 facilities to submit monthly

reports of their time allocation. The company employed 14 people full-time

just to manage the data collection, processing, and reporting.

Taking the example in consideration and as explained before, the initial approach of the ABC

costing system does not work well when there is too many participants, processes and

activities, as it gets too difficult to control and moreover the demanding time and costs of

maintaining this system on that scale turns to a major barrier to adopt it in most of companies

(Kaplan & Anderson, 2004). Additionally, sometimes adopting this costing system fails

because the company misses to capture the complexity of their processes.

Having analyzed the ABC costing system’s advantages and limitations I can confirm

that is much better than the traditional one, as well is important to highlight that ABC costing

system can be a great tool to use in a company but it must be raised, reviewed and controlled

carefully. Its benefits are many more than the explained in the previous paragraphs, and

according to Ness an Cucuzza (1995) “ABC can be much more than a superior accounting

technique that shows how much money individual products are really making or losing”, so a

company must look for the ABC costing system to be interlinked with all the management

systems of the company in order to become a tool that allows not only to continuously

improve the products but also the processes and strategies of the company.
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References

Amat, O., & Soldevilla, P. (1997). Contabilidad y gestión de costes. Madrid: Gestión 2000.

Arias, L.; Portilla, L.; & Fernández, S. (2010). La distribución de costos indirectos de

fabricación, factor clave al costear productos. Scientia et Technica, 1(45), 79-84).

Business Encyclopedia (September 11th, 2017a). Activity Based Costing and ABC

Management. Retrieved from https://www.business-case-analysis.com/activity-based-

costing.html

Business Encyclopedia (December 11th, 2017b). Cost Allocation and Cost Apportionment.

Retrieved from https://www.business-case-analysis.com/cost-allocation.html

Cuevas, C.; Chávez, G.; Castillo, J.; Caicedo, N.; & Solarte, W. (2004). Costeo ABC: ¿Por

qué y cómo implantarlo?. Estudios Gerenciales, 20(92), 47-103.

Franco, O. (1995). Sistemas de costos basado en actividades. Pasado, presente y futuro.

Revista Costos y Gestión, 4(15), 251-252.

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tradicional-y-el-sistema-de-costos-abc.html

Giménez, C., Kaplan, R., Mallo, C., & Meljem, S. (2001). Contabilidad de costos y

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Empresarial, 1(195), 1-5.

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Isidro, G. (2014). Criterios para distribuir los costos indirectos de fabricación. Actualidad

Empresarial, 1(309), 1-5.

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Kaplan, R. (January, 1998). One Cost System Isn’t Enough. Retrieved from

https://hbr.org/1988/01/one-cost-system-isnt-enough

Kaplan, R.; & Anderson S. (November, 2004). Time-Driven Activity-Based Costing.

Retrieved from https://hbr.org/2004/11/time-driven-activity-based-costing

Ness, J.; & Cucuzza, T. (August, 1995). Tapping the Full Potential of ABC. Retrieved from

https://hbr.org/1995/07/tapping-the-full-potential-of-abc

Sanchez, B. (2013). Implicancias del Método de Costeo ABC. Quipukamayoc Revista de la

Facultad de Ciencias Contables, 21(39), 75-73.

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