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In the traditional system of assigning manufacturing overheads, overheads are first allocated and apportioned to cost centres (production and support service cost centres) and then absorbed to cost objects (e.g. products). Under ABC, overheads are first assigned to activities or activity pools (group of activities) and then they are assigned to cost objects. Thus, ABC is a refinement over the traditional costing system. Usually cost centres include a series of different activities. If different products create different demands on those activities, the traditional costing system fails to determine the product cost accurately. In that situation, it becomes necessary to use different rates for different activities or activity pools.
The following are the reasons for adoption of ABC by manufacturing and non-manufacturing industries:
(i) Fierce competitive pressure has resulted in shrinking profit margin. ABC helps to estimate cost of individual product or service more accurately. This helps to formulate appropriate marketing / corporate strategy.
(ii) There is product and customer proliferation. Demand on resources by products / customers differ among product / customers. Therefore, product / customer profitability can be measured reasonably accurately, only if consumption of resources can be traced to each individual product / customer.
(iii) New production techniques have resulted in the increase of the proportion of support service costs in the total cost of delivering value to customers. ABC improves the accuracy of accounting for support service costs.
(iv) The costs associated with bad decisions have increased substantially.
(v) Reduction in the cost of data processing has reduced the cost of tracking resources consumption to large number of activities.
(iii) New production techniques have resulted in the increase of the proportion of support service costs in the total cost of delivering value to customers. ABC improves the accuracy of accounting for support service costs.
(iv) The costs associated with bad decisions have increased substantially.
(v) Reduction in the cost of data processing has reduced the cost of tracking resources consumption to large number of activities.
