How Does Activity-Based Costing Compute Better Accuracies?
ABC/M was developed as a practical solution for problems associated with traditional cost management systems that we now realize are distorting and incomplete. Indirect expense and overhead cost allocation practices of traditional systems can bring more damage than good to organizations. In traditional cost- ing the indirect expenses are usually too aggregated to serve any purpose, and these large groupings destroy any likelihood for calculating an accurate cost of any type of output.
The next problem with overhead cost allocations is that excessively broad- brush average cost rates are applied to calculate costs. Worse yet, the cost allocations usually rely on a sales-related, volume-based factor or basis, such as direct labor hours or department expenses. It may be an inputs-used or outputs-produced basis measure, but the basis usually will not accurately measure the segments of the total. This flawed basis for allocating costs rarely reflects the specific cause-and-effect relationship between the indirect overhead expense and the work output, part, product, service, channel, or customer (i.e., the cost object) that is actually consuming the cost. Many managers are tired of “allocation foodfights.”
The result of inaccurate cost allocations, because allocating is a zero-sum error game, is that some cost objects are over-costed while the remainder are under-costed. In other words, as a consequence of unquestioned formula cost allocations, traditional financial accounting can grotesquely distort the true cost of products and service lines, which in turn can wildly distort their individual profit margins. Some refer to traditional cost allocation methods as “spreaders.”
The ABC/M logical assignment of expenses and costs obliterates the use of simple averages as the basis for tracing costs. In practice, one discovers that the under-costed products are substantially under-costed because these products may be low-volume with small lot sizes, require more technical attention, consume more handling, or need extra inspection. ABC/M removes the distortions from simplistic cost allocations. An allocation-free cost system is like a smoke-free environment: no pollution. In short, don’t allocate, prorate. In the end, ABC/M is like bringing in the “myth grenades” that blow up the old flawed beliefs and replace them with real facts.