Costs incurred by a business are classified into two types

a) Direct Costs
b) Indirect Costs

Costs which can be traced to the finished product or service are called ‘direct costs’. On the other hand, costs which cannot be traced to the finished products or service are called ‘indirect costs’. Indirect costs are also known as ‘Overhead cost’. As a small business owner, it is easy to allocate direct cost to the product or service produced. But what about overhead? Allocating overhead could be quite tricky and there are many methods of doing this (some more accurate than others).

Importance of overhead allocation

Accuracy of product or service cost computation depends on accurate distribution of overhead to products or services. Inaccuracies would lead to incorrect business decisions (especially pricing decisions). Also incorrect overhead allocation causes cost distortion in which the proposed cost of the product is totally different than the actual cost. However, the method chosen for overhead distribution should consider time and cost factors in addition to accuracy.

What is ABC

Traditionally overhead apportionment to products was made using a predetermined overhead rate. This method used one cost driver which traditionally was based on labor or machine hours. Activity based costing (ABC) assigns manufacturing overhead costs to products in a more logical manner than the traditional approach of simply allocating costs on the basis of labor or machine hours. Activity based costing first assigns costs to the activities that are the real cause of the overhead. It then assigns the cost of those activities only to the products that are actually demanding the activities.

Advantages of ABC

One of the greatest advantages of the ABC system is the standardization for the business. When everything is standardized and everything is done the exact same way each time, things are a lot easier to measure and predict. Another advantage of the ABC system is the ability to track the direct costs as well as the variable costs. It gives a whole picture of the numbers which comes in very handy for the decision makers. ABC system also spurs new ideas: When you can see the whole picture of the numbers, you can come up with new and creative ideas on how to work the process better for the company.

Disadvantages of ABC

As for disadvantages, the biggest would be the issue of recording cost drivers. Having so many different variables to track can be very difficult. You do not want to count the costs twice or put them in the wrong category, which would show more costs in the wrong places. This makes it hard to decide where things should be recorded. It is also hard to figure out how to measure these costs.

Problems with misappropriating cost

If you are under costing your products, you are definitely not seeing the right numbers of cost versus profit of your products. Knowing how many hours you need to produce a product or service should be tracked so you are better armed with the true cost of producing one unit of your product or service. Without carefully keeping track of cost, you run the risk of misappropriating cost and making poor pricing decisions. The whole basis of costing everything out is to ensure that the company is making a lot more profit than it cost to make the product or service. To do this, every cost that is incurred needs to be documented and compared to the product profit. By doing this, the company ensures that they are making money rather than losing it in the production process.

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