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Unit 13: Activity-based Costing

of indirect activities is a small percentage compared to direct labour component in actual making Notes
of products. However, the increased technology and automation has reduced the direct labour
considerably and so the indirect activities have assumed greater importance. Therefore, using
the direct labour as a basis for absorbing the overheads can lead to distortions in the costs.
Distortions in the costs resulting into incorrect cost calculations may lead to following wrong
decisions.

 Errors in fixation of selling prices.
 Wrong decisions regarding deciding of product mix.
 Ignoring customer orientation.
 Missing of profitable opportunities.
In order to overcome the limitations of traditional costing systems, activity-based Costing has
been introduced.
Before we proceed to the other aspects of Activity-based Costing, let us see the limitations of
traditional costing system. A brief mention of the same has already been made in the above
paragraph. Some more points are discussed below.

13.1 Limitations of Traditional Costing System

The following are the limitations of traditional costing system.
 In a traditional costing system, overheads i.e. indirect costs are allocated, apportioned and
finally absorbed in the cost units. There can be distortion in computing costs due to the
basis selected for absorption.

Example: Suppose a manufacturing company is producing two products, A and B. The
direct material cost for the products is ` 1,00,000 and ` 2,00,000 respectively. The total overheads
are ` 1,50,000 and the company adopts direct material cost as the basis for absorption. The
absorption percentage of overheads will be 50% of the direct material. [1,50,000/3,00,000 × 100
= 50%] Thus the overheads absorbed in the product A will be ` 50,000 and for B, they will be
` 1,00,000 [50% of the overheads] Product B has a larger share of the overhead costs as the
material costs are higher than that of A. However, actually product B may be requiring lesser
efforts in the indirect activities than A, but only because it has a higher material costs, it will be
charged with larger amount of overheads. Thus there is a distortion in the total cost. This
distortion in costs may lead to wrong decisions in several areas like make or buy, pricing
decisions, acceptance of export offer etc.
 Another limitation of traditional costing system is the division between fixed and variable
may not be realistic as there are many complications due to the complexity of the modern
business.
 There should be linkage between the activities and the costs. Similarly the information
should be available simultaneously which means that information should be made
available while the activities are going on. Information available after the activity is over
will not be of much use.

Did u know? The Activity-based Costing system has been developed due to the limitations
of the traditional costing system.

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