Managers choose the level of detail of a costing system by evaluating the expected costs of the system against the expected benefits of better decisions that result from more accurate cost information.
Here are some of the telltale signs that implementing an ABC system is likely to provide significant benefits and improvements over an existing costing system:
When managers decide to implement ABC, they must make important choices about the level of detail to use. Should managers choose many finely specified activities, cost drivers, and cost pools, or would a few suffice? For example, Plastim’s managers could identify a different molding machine-hour rate for each of the different types of molding machines. In making such choices, managers weigh the benefits against the costs and limitations of implementing a more detailed costing system.
The main costs and limitations of an ABC system are the measurements necessary to implement it. ABC systems require managers to estimate costs of activity pools and to identify and measure cost drivers for these pools to serve as cost-allocation bases. Even basic ABC systems require many calculations to determine costs of products and services. These measurements are costly. Activity-cost rates also need to be updated regularly.
As ABC systems get very detailed and more cost pools are created, more allocations are necessary to calculate activity costs for each cost pool, which increases the chances of misidentifying the costs of different activity-cost pools. For example, supervisors are more prone to incorrectly identify the time they spend on different activities if they have to allocate their time over five activities rather than only two activities.
Occasionally, managers are forced to use allocation bases for which data are readily available rather than allocation bases they would have liked to use but for which data are difficult to obtain. For example, in its ABC system, Plastim’s managers measure mold complexity in terms of the number of parts in the mold and the surface area of the mold (parts-square feet). If these data are difficult to obtain or measure, Plastim’s managers may be forced to use some other measure of complexity, such as the amount of material flowing through the mold, that may only be weakly related to the cost of the design activity.
When incorrect or imprecise cost-allocation bases are used, activity-cost information can be inaccurate and even misleading. For example, if the cost per load moved decreases, a company may conclude that it has become more efficient in its materials-handling operations. In fact, the lower cost per load moved may have resulted solely from moving many lighter loads over shorter distances.
Many companies, such as Kanthal, a Swedish heating elements manufacturer, have found the strategic and operational benefits of a less-detailed ABC system to be good enough to not warrant incurring the costs and challenges of operating a more detailed system. Other organizations, such as Hewlett-Packard, have implemented ABC in only certain divisions (such as the Roseville Networks Division, which manufactures printed circuit boards) or functions (such as procurement and production). As improvements in information technology and accompanying declines in measurement costs continue, more detailed ABC systems have become a practical alternative in many companies. With these advancements, more detailed ABC systems are able to pass the cost–benefit test.
Global surveys of company practices suggest that ABC implementation varies among companies. Nevertheless, the framework and the ideas underlying ABC provide a standard for judging whether any simple costing system is good enough for a particular management purpose. ABC thinking can help managers improve any simple costing system.