Importance of Activity Based Costing (ABC)
Activity based costing does not only apply to manufacturing organizations: it is also appropriate for service organizations such as financial institutions, medical care providers and government units. In fact, some banking companies have been applying the concept for years under another name – unit costing.
Unit costing is used to calculate the cost of banking services by determining the cost and consumption of each unit of output of functions required to deliver the service.
A major advantage of using ABC is that it avoids or minimizes distortions in product costing that result from arbitrary allocations of indirect costs. Unlike more traditional line-item budgets which cannot be tied to specific outputs, ABC generates useful information on how money is being spent, if a department is being cost-effective, and how to benchmark (or compare oneself against others) for quality improvements.
Activity-Based Costing also provides a clear metric for improvement. It encourages management to evaluate the efficiency and cost-effectiveness of program activities. Some ABC systems rank activities by the degree to which they add value to the organization or its outputs.
This helps managers identify what activities are really value- added—those that will best accomplish a mission, deliver a service, or meet customer demand—thus improving decision-making through better information, and helping to eliminate waste by encouraging employees to look at all costs. That is why an essential aspect of any ABC endeavor is to get a clear picture of the activities a business area performs. When employees understand the activities they perform, they can better understand the costs involved.