Activity Based Costing Treats Organization Sustaining Costs As

Activity-Based Costing: Treating Organization Sustaining Costs

Activity-based costing (ABC) is a method of assigning costs to products and services based on the activities that create them. Unlike traditional costing methods, which allocate overhead costs based on volume measures like direct labor hours or machine hours, ABC identifies and assigns costs to specific activities that drive those costs. This granular approach is particularly useful in addressing a critical question: how does ABC treat organization-sustaining costs?

Understanding Organization-Sustaining Costs

Organization-sustaining costs are those incurred to support the entire organization, rather than being directly tied to individual products or services. These costs are necessary for the business to operate but don't directly contribute to the creation of a specific product or service. Examples include:

• Executive salaries: The compensation of top management is essential for strategic direction but isn't directly linked to a single product.
• General and administrative expenses: Costs associated with accounting, human resources, legal, and other administrative functions are crucial for the organization's overall functioning but aren't directly attributable to specific products.
• Facility costs: Rent, utilities, and maintenance of the overall facility are necessary for operations but are not directly tied to the production of specific goods or services.
• Research and Development (R&D) for general improvements: While R&D focused on a specific product is easily assigned, general R&D aimed at improving overall processes falls under organization-sustaining costs.
• IT infrastructure: The cost of maintaining the organization's IT systems supports all operations but isn't specifically tied to any one product or service.

Traditional costing systems often struggle to allocate these costs effectively. They might arbitrarily assign them based on simple volume measures, leading to inaccurate cost estimations and potentially flawed pricing decisions. ABC offers a more sophisticated approach.

ABC's Treatment of Organization-Sustaining Costs

ABC doesn't directly assign organization-sustaining costs to individual products or services. This is because these costs are, by definition, not directly caused by the production of specific goods or services. Instead, ABC recognizes these costs as a separate category and treats them as part of the overall cost structure of the organization. The approach varies depending on the level of detail desired and the complexity of the organization's cost structure. Here are common methods:

1. Separate Allocation:

This is the simplest approach. Organization-sustaining costs are treated as a separate pool of costs and allocated proportionally across products or services based on a suitable cost driver. This driver might be revenue, unit sales, or even a weighted average of various factors. While simpler, it lacks the precision of other methods.

Example: If a company has total organization-sustaining costs of $1 million and total revenue of $10 million, each product line is assigned a portion of the $1 million based on its proportion of the total revenue. A product line generating $2 million in revenue would be allocated $200,000 of organization-sustaining costs.

2. Activity-Based Allocation using Cost Pools:

A more refined approach involves creating cost pools for organization-sustaining activities. This method breaks down the organization-sustaining costs into more manageable categories, each with its own cost driver.

Example: Instead of treating all organization-sustaining costs as one pool, the company might create separate cost pools for:

• Executive management: Cost driver could be the number of employees supervised.
• General administration: Cost driver could be the number of transactions processed.
• Facility maintenance: Cost driver could be the square footage occupied by each product line.

Each cost pool's costs are then allocated to product lines or services based on their consumption of the relevant cost driver. This offers a more precise allocation than a simple proportional allocation.

3. Combined Approach:

A more comprehensive approach involves a combination of the above methods. Some organization-sustaining costs might be allocated proportionally, while others are allocated based on activity-based cost pools. This allows for flexibility and tailoring the approach to the specific cost structure of the organization.

4. Identifying Cost Drivers:

A crucial aspect of handling organization-sustaining costs within an ABC system is the identification of appropriate cost drivers. These drivers should accurately reflect the consumption of resources by each product line or service. Choosing the wrong driver can lead to inaccurate cost allocation and distorted product profitability. Careful analysis is needed to select drivers that truly reflect the causal relationship between the organization-sustaining activities and the products or services.

Benefits of ABC's Approach to Organization-Sustaining Costs

ABC’s approach to organization-sustaining costs offers several key benefits:

• Improved Accuracy: By moving away from arbitrary allocations, ABC provides a more accurate representation of the true cost of products and services. This leads to better pricing decisions, improved profitability analysis, and more informed strategic planning.
• Enhanced Cost Management: The detailed analysis inherent in ABC helps organizations identify areas where organization-sustaining costs can be reduced. By understanding which activities drive these costs, managers can make data-driven decisions to streamline processes and eliminate inefficiencies.
• Better Product Decisions: Accurate cost information enables more informed decisions regarding product mix, pricing, and product discontinuation. Knowing the true cost of each product helps in making strategic decisions that maximize profitability.
• Improved Performance Measurement: ABC provides a more nuanced understanding of the organization’s cost structure. This improved transparency enables more effective performance measurement and accountability.

Limitations of ABC's Approach to Organization-Sustaining Costs

Despite its advantages, ABC's approach to organization-sustaining costs also presents some limitations:

• Complexity: Implementing ABC can be complex and time-consuming, requiring significant data collection and analysis. The process can be costly and require specialized expertise.
• Subjectivity: Selecting appropriate cost drivers for organization-sustaining costs can involve some degree of subjectivity. Different choices of cost drivers can lead to different cost allocations.
• Difficulty in Defining Activities: Clearly defining activities and their relationships to organization-sustaining costs can be challenging. The boundaries between different activities might be blurry, leading to ambiguity in cost allocation.

Conclusion:

Activity-based costing offers a more sophisticated and accurate way of dealing with organization-sustaining costs compared to traditional costing methods. While it presents some complexities, the enhanced accuracy and insight it provides significantly outweigh the limitations. By carefully selecting appropriate cost drivers and employing a suitable allocation method, organizations can use ABC to gain a clearer understanding of their cost structure, leading to better decision-making and improved profitability. The key is to tailor the ABC approach to the specific needs and complexity of the organization, striving for a balance between accuracy and practicality. Remember, the goal is not simply to assign costs but to understand the drivers of those costs, providing a pathway for more effective cost management and strategic decision-making. Implementing ABC is a significant undertaking, requiring careful planning, data collection, and ongoing monitoring, but the rewards of a more accurate and insightful view of organizational costs are significant.