Activity-based costing (ABC) is a concept which refers to the accounting method whereby the costs are identified and assigned to the overhead activities and subsequently to the products. As such, an activity based costing is a method that recognizes the relationship between costs, overhead activities and the products. Consequently, through this relationship, the method assigns indirect costs to the products less indiscriminately as compared to the traditional methods (Kenton, 2018). However, using this method of activity based costing, some costs often become difficult to assign. For instance, indirect costs such as office staff salaries and management sometimes become very difficult to assign to the products. As a consequence, this method is usually applied in the manufacturing industry because in enhances the reliability of cost data thus producing almost accurate costs and results into better cost classification as incurred by the company during the production process. Furthermore, the method is important in product line profitability analysis, product costing, service pricing and customer profitability analysis.
The ABC method is based on activities which refers to any unit of work task or event such as setting up machines for production purposes, distribution of finished products, operating machines, designing products, among others. Since the activities use overhead costs, they are considered cost objects. In addition, under this system, an activity may refers to any event or transaction that is a cost driver. A cost driver, which is also referred to as an activity driver, is used to denote an allocation base. Some of the examples of cost drivers include power consumed, machine setups, maintenance requests, quality inspections, purchase orders and production orders. On the other hand, activity measures are categorized into two groups including transaction drivers and duration drivers. Transaction drivers pertains to counting of the number of times an activity occurs whereas duration drivers measure the length of time an activity takes to complete.
Activity based costing is effective in the process of improving the costing process in three different ways. First, it increases the number of cost pools that are used to group overhead costs. As such, instead of grouping all costs of a company into one large pool, the method groups the pools based on activities. In addition, it comes up with new bases for allocating overhead costs to items. As a result, the costs are allocated depending on the activities responsible for the costs and not the volume measures such as direct labor costs or machine hours. Finally, the ABC method changes the nature of most of the indirect costs thus it makes costs that were previously considered indirect such as power, inspection and depreciation to be attributable to certain activities. According to Kenton (2018), the ABC method transfers overhead costs from products with high volume to those with low volume thus raising the unit costs of low volume products.
Ethical Issues in the Scenario
The controller Erin Jackson is indeed acting ethically. First, upon realizing that the deluxe-model electric motor is running at a loss, she set out to introduce a new costing method that would be more profitable to the company. In addition, despite the fact that Alan Tylor, the production manager for deluxe-model electric motor, is her personal friend, she refuses to bow to her pressure to abandon the new costing method and to change the figures so that Alan cannot lose her job. Finally, she promises to revise her figures to see if she had made any errors. On the contrary, Alan Tylor is not acting ethically by requesting Erin to massage the number a little bit to prevent her from losing her job. Her request therefore means that she is putting her personal desires before the goals of the company. Jackson’s ethical obligation is to the entire company including the president and her friend. As such, she ought to make ethical considerations based on the views of all the members of the company.
Kenton, W. (2018). Activity-Based Costing (ABC). Investopedia.