Activity-based costing (ABC) is a methodology for more precisely allocating overhead to those items that actually use it. The system can be used for the targeted reduction of overhead costs. ABC works best in complex environments, where there are many machines and products, and tangled processes that are not easy to sort out. Conversely, it is of less use in a streamlined environment where production processes are abbreviated.
Activity Based costing System is a more accurate method for cost allocation to products. It identifies the activities as the fundamental cost objects. The ABC costing system assumes that activities cause the costs. Thus the indirect costs are allocated to the products on the basis of the activities required for their production. The costing approach relates the cost to the activity. An activity-based costing (ABC) system first traces costs to activities and then to products. Under the system cost are not assigned to the products directly but are assigned to the activities and charged to the products on the basis of the activities utilized by them.
Activity Cost Pool are the cost of each activity identified. Overheads are identified to the cost pool based on the cost driver. Cost Driver is the activity that proves cause and effect the relationship with the overhead cost and the cost pool. The cost pools are assigned to the products on the basis of the cost driver.
ABC costing can provide overall benefit to every organization. ABC costing aims at assigning the cost to the products in dollar amount that would reflect the reasonable cost of the resources consumed by the product (Lindahl W., 1997). Some cost of resources which are easy to account for the product as they can be directly associated with the production of the product like ink in the pen, paper in the Book, however the challenge lies in accounting for the cost of the resources where the connection between the resource and the product manufactured is indirect and not precise, like repair and maintenance to the machinery used for the production of multiple products. ABC helps in associating this indirect cost to the products based upon the quantum of services utilized by the product irrespective of the volume of its production. Besides allocation of cost to the product accurately ABC also helps in managing cost by providing detailed information about the cost and its behaviour (Thorne, H. and G. Gurd., 1999). Thus ABC will help an organization to identify the cost of its product more specifically and accurately and then control the cost. The use of ABC helps the management in making decisions regarding the production of the products and quantity produced. Thus ABC helps in developing the detailed and successful Decision support system (DSS), we can say that ABC costing will be suitable for both manufacturing as well as service organizations. (Cho, Charles H, Boulianne, Emilio, 2005).
At the same time, we can also say that ABC in service sector is applied only in typical service industries such as banking sector, health care and logistics and that too in a modified version which is Time Driven Activity Based Costing, TDABC which unlike ABC which usually collects the proportion of time, TDABC is more interested in actually time spend for particular activities. Second and the most importantly, TDABC uses simpler procedure to estimate cost. As mentioned previously, TDABC avoids the costly, time consuming and subjective activity surveying tasks. It is possible because TDABC assigns resource costs directly to the cost objects (such as transactions, orders, products, services and customers) by using only two set of parameters through a simple framework. Thus we can say that in a service organization the basis ABC method is not appropriate but a modified form of TDABC is applicable.