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As stated above, traditional absorption costing is designed to provide data for external financial reports. In contrast, activity-based costing is designed to be used for internal decision making. As a consequence, activity-based costing differs from traditional absorption costing in three ways. In activity-based costing:

1. Nonmanufacturing as well as manufacturing costs may be assigned to products, but only on a cause-and-effect basis.
2. Some manufacturing costs may be excluded from product costs.
3. Numerous overhead cost pools are used, each of which is allocated to products and other cost objects using its own unique measure of activity.

Each of these departures from traditional absorption costing will be discussed in turn.

Nonmanufacturing Costs and Activity Based Costing

In traditional absorption costing, manufacturing costs are assigned to products and non-manufacturing costs are not assigned to products. Conversely, in activity-based costing, we recognize that many nonmanufacturing costs relate to selling, distributing, and servicing specific products. Thus, ABC includes manufacturing and nonmanufacturing costs when calculating the entire cost of a product rather than just its manufacturing cost.

There are two types of nonmanufacturing costs that ABC systems assign to products. First, ABC systems trace all direct nonmanufacturing costs to products. Commissions paid to salespersons, shipping costs, and warranty repair costs are examples of nonmanufacturing costs that can be directly traced to individual products. Second, ABC systems allocate indirect nonmanufacturing costs to products whenever the products have presumably caused the costs to be incurred. In fact, in this chapter, we emphasize this point by expanding the definition of overhead to include all indirect costsómanufacturing and nonmanufacturing.

In summary, ABC product cost calculations include all direct costs that can be traced to products and all indirect costs that are caused by products. The need to distinguish between manufacturing and nonmanufacturing costs disappearsówhich is very different from earlier chapters that focused solely on determining the manufacturing cost of a product.

limitations:

Implementing an activity-based costing system is a major project that requires substantial resources. And once implemented, an activity-based costing system is more costly to maintain than a traditional costing systemódata concerning numerous activity measures must be periodically collected, checked, and entered into the system. The benefits of increased accuracy may not outweigh these costs.

Activity-based costing produces numbers, such as product margins, that are at odds with the numbers produced by traditional costing systems. But managers are accustomed to using traditional costing systems to run their operations and traditional costing systems are often used in performance evaluations. Essentially, activity-based costing changes the rules of the game. It is a fact of human nature that changes in organizations, particularly those that alter the rules of the game, inevitably face resistance. This underscores the importance of top management support and the full participation of line managers, as well as the accounting staff, in any activity-based costing initiative. If activity-based costing is viewed as an accounting initiative that does not have the full support of top management, it is doomed to failure.

In practice, most managers insist on fully allocating all costs to products, customers, and other costing objects in an activity-based costing systemóincluding the costs of idle capacity and organization-sustaining costs. This results in overstated costs and understated margins and mistakes in pricing and other critical decisions.

Activity-based costing data can easily be misinterpreted and must be used with care when used in making decisions. Costs assigned to products, customers, and other cost objects are only potentially relevant. Before making any significant decisions using activity-based costing data, managers must identify which costs are really relevant for the decision at hand. See Appendix 6A for more details.

As discussed in the previous section, reports generated by the best activity-based costing systems do not conform to external reporting requirements. Consequently, an organization involved in activity-based costing should have two cost systems one for internal use and one for preparing external reports. This is costlier than maintaining just one system and may cause confusion about which system is to be believed and relied on.