I am lucky enough to encounter this type of costing system in my recently joined company, practice this system in reality is no doubt complicated. The idea of employing this system into the modern manufacturing environment, direct costs such as labor and material costs are reduced.
In fact, will you see workers paid by piecework now? Does material carries the significant cost to produce goods? Not anymore. Workers are now paid by monthly salary, thanks to our government and union. Technological advancement has eliminated traditional manufacturing system, or at least reduced to minimal. For example, software that we are using nowadays - are they made up from "materials"? Think about it again.
In simple words, Activity-based Costing (ABC) is used to identify what has causes the overall costs in order to provide the service or goods to the consumer or end user. Most of the costs now are fixed and difficult to allocate: labor costs if an IT staff is worked for a software development and also normal office supporting, electricity and rentals, administration staff costs, management costs, and etc.
Overheads are no more affected by the volume of production but activities. Customer service costs goes higher when there are increasing amount of complaint calls, which is also affected by other qualitative reasons like, production staffs are not motivated to work. By using ABC, these causes are able to be identified and analyzed; correction can be carried out accordingly.
The complexity and wider range of products and services provided by companies today are so much different from traditional companies. Traditional companies produced the goods and sell, while modern companies tend to focus on after-sales service, goods returns rate, quality of goods, warranty, insurance, delivery time and so on.
These activities are more concern with customer satisfaction rather than simply production of goods. Thus, the more complex and the wider range of the products, the more support activities will be required. And therefore, it is critical for managers to understand the factor which increases costs to a certain activity. These are known as cost drivers. Examples are as following:
