Activity-based costing is an method of assigning overhead costs to products based on the idea of cost pools. Traditional costing systems use a plant-wide overhead rate to assign overhead to products based on the annual estimated overhead and an allocation base. The philosophy underlying activity-based costing is that a company's activities are what produce overhead, not an artificial allocation base, and therefore, decision-makers should be looking at overhead application in that manner. Activity-based costing has advantages and disadvantages, and understanding the pros and cons can help you decide whether activity-based costing is right for your business.

Overhead Application Flexibility

An important advantage of activity-based costing is that overhead rates are calculated based on each activity pool, not just using the entire factory. This allows for overhead rates to be determined with more precision and overhead application to occur based on specific actions. For example, under the traditional costing system, a small business might determine that, in general, overhead is related to direct labor hours and use direct labor hours to calculate the company's overhead rate. However, in an activity-based costing system, the company is able to precisely specify that in the customer service cost pool, overhead is incurred each time a customer calls into the call center, and use this more precise measure as the overhead driver.

Relevant Cost Application

Traditional costing systems require that all manufacturing costs are assigned to products. However, activity-based costing systems allow small business owners to exclude costs that are not relevant to decision-making from cost calculations. For example, costs related to factory security are considered manufacturing costs under traditional costing systems and, therefore, must be assigned to products. Under activity-based costing, these costs considered to be organization-sustaining costs are not assigned to products. This allows small business owners to only consider costs that are relevant to the manufacturing to be included in decision-making analyses.

Implementation Time

Even for smaller businesses, the implementation of an activity-based costing system can be a substantial undertaking. The added precision of the activity-based system can only be achieved if the small business owner is willing to put in the time to analyze the manufacturing process with enough detail to determine how overhead costs are incurred. Due to the difficulty of implementation, many small business owners don't believe the benefit of an activity-based system outweighs the costs.

Duplication of Costing

Unlike traditional costing systems, which are required under generally accepted accounting principles, activity-based costing systems are optional. Further, activity-based costing systems are unable to take the place of traditional costing based systems. As such, designing, implementing and maintaining an activity-based costing system is a completely incremental cost to the company's traditional system. This makes the adoption of an activity-based system costly for small business.