In traditional costing system it was a simple method because it was made for a simple era , imagine why would Mr Ford need to worry anything in traditional costing after all , he had to produce only one thing and that was black cars . Ford wasn't changing any model in earlier days , forget about model he wasn't even changing colors of the cars and in such a case traditional costing made perfect sense where all the overhead and other costs were proportioned equally to the number of units produced . there was hardly any confusion or apprehension about costing .
No one would have imagined in those days that a process as simple as finding out cost of labor , material , sales and administration and allocating it to number of units will become so creative in coming days. Very soon days of monopoly and cost plus were on their out from industry , it was time to produce more and with various varieties . ( just after one decade GM would have near 8000 model of cars in its portfolio). Then started the problem , not all the product needed same kind of materials neither were they produced by similar processes . Some of them were simple and needed easily available materials but some were specific which needed expensive material and special treatments. In fact Cost differentiation started much before manufacturing , In case of motherboard , chips or other research extensive electronics product research and design also contributed to the cost and determined the way these products need to be produced during manufacturing.
These complexities gave birth to a new comprehensive and creative way of costing , Activity based costing where no longer the cost was a simple function of direct labour , direct material with equal distribution of overhead to all the products . In ABC each phase of product lifecycle was divided into various activities and cost incurred in each activities was calculated , this obviously gave a clearer picture rather then a generic overview.
What were some of the basic points to consider while deciding between ABC and traditional cost.
Disillusionment : At times traditional cost created illusions , lets take a very bookish example which is there in almost all costing books . If a car manufacturer is manufacturing cars of two types one is standard cars which are made in assembly line and completely automated whereas another types of cars are competing head on with Maybach ( Remember these high end cars in which entire interiors is done by hands) and after making these two kind of cars he is simply dividing the total cost incurred in making them by number of units produced , obviously he would now find that the margin for his standard cars have decreased .....
traditional costing created this kind of false illusions for management which may lead to disastrous decisions like closing down production of standard cars or increasing the price of these cars . ABC helped management in such situations by providing them precise information
Hitting right on the correct problem : In earlier days when major portion of motherboard fabrication was done by hands in HP , they found that over all cost for motherboards was high and the obvious blame was on manufacturing . What they missed is two things
1) How will the device be manufactured is decided much earlier in design phase
2) Manual fabrication is much costlier then automated manufacturing.
These are typical example where either a product need some special treatment or one of the process in product development is eating larger chunk f resources then other processes . In such case we need to concentrate only on those pain areas.
Traditional costing could have never detected these issues , it was again ABC which came to the rescue .
Importance for service industry : Traditional costing could have never done justice to service industry . In service industry there is no tangible product to be delivered , every service is simply combination of activities . To find out which activity is costliest you need to apply ABC and once you have done so , you can decide on next strategic move , whether you should keep such activity with you or outsource it to some third party vendors.
Similarly there is one very crucial question which traditional costing will never be able to answer and that is which customer is causing more cost or which is the most profitable customer.
In short here ABC can help you providing right set of services to right set of customers
