Define activity-based costing. Explain why this approach to cost assignments is superior to the traditional method of using a plantwide overhead cost rate. Will activity-based costing always result in lower product costs? Justify your answer

Answer 1

Activity-based costing is an approach to cost assignment that identifies all major operating activities, categorizes costs by activity, reduces or eliminates nonvalue-adding activities, and assigns costs using a basis that causes the costs to be incurred. ABC assigns costs using many different activities and cost drivers (allocation bases) and, in turn, significantly improves the traceability of costs to products. Using one overhead rate assumes that all costs are caused by one basis, which is not true. By tracing costs to the activities that cause the costs and then by determining the amount of each activity used by a product or batch of products, costs can be traced more accurately.
No, ABC will not always result in lower product costs, at least in the short run. Improving cost traceability may result in lowering some product costs while increasing others. But over the long run, if all nonvalue-adding activities are reduced or eliminated, all product costs will benefit.