Activity based costing, control and risk management

Abstract

In larger organisations with multiple products (goods or services) and more than one producing department, the simplistic nature of a single organisational wide overhead rate can distort product costs. If products spend significant time in labour intensive departments, but the organisation-wide absorption/ allocation rate is based on machine hours, then those products' costs will in all probability be distorted. This can adverselv affect costing accuracy control decisions, pricing, and product mix decisions.

In order to address these decision-information implications, service department costing tools, techniques and frameworks were developed. The service department costing approach to the allocation of overhead costs recognises the information deficiencies of the organisation-wide allocation rate. It addresses these deficiencies through the use of multiple producing cost centres, each with a specific allocation base. Further, the costs of service departments that support the producing departments are allocated using appropriate bases. However, while this should produce more accurate product costs than the use of a single organisation-wide allocation rate, and hence provide better information for pricing and product-mix decisions, it does result in costs being charged to producing departments over which they have little or no control. This can lead to dysfunctional management and staff behaviour. To address this issue, the technique of activity-based costing (ABC) has been developed (Garrison, Noreen & Brewer, 2006; Drury, 2005; Adams, 1995; Coy & Goh, 1993; Cooper, 1989). This chapter explains the difference between ABC and traditional costing. It then demonstrates and discusses ABC and the management issues associated with its use.