Let's talk about some refinements to the job costing system and the process costing system that we introduced in the last video. Let's think about the different categories of costs. Direct materials and direct labor, we know what those are. And usually, firms have a good understanding of what those costs are because they're specialist in their products that they're producing. The trouble child here is usually overhead. Overhead includes many different costs. Costing systems, because of this, often rely on an estimation process to account for products' share of overhead costs. In a traditional system, we would have these three categories. Direct materials, direct labor, and overhead. And organizations oftentimes, keep things relatively simple, with respect to overhead. They might have a couple of different pools that they break overhead down into. The manufacturing overhead, if this was a good base product, and then perhaps other sorts of administrative or supporting overhead, such as customer service. And then these pools compile a variety of different types of overhead, and then it's split up over the various products using an estimation process. Now the problem with that Is that many scenarios often call for a greater accuracy. Meaning that we need better cost information to make decisions, rather than just smoothing overhead over the products on an average or estimated basis. So, what we need is a different type of system. And the answer here is activity-based costing. Activity-based costing is a costing method that focuses on organizing costs not according to overhead categories, but according to activities. It takes a more real view of what the firm's activities actually are. And the mantra in this costing system is that activities use resources. As resources are used up according to the activities, the firm is engaged as incurring costs. The design of activity-based costing, or its intent, is to increase the accuracy of cost information. Let's have a checkpoint and explore this issue a little further. So now to differentiate activity based costing from a traditional costing system, let's go back to our schematic. Again, we have direct materials, and direct labor, and then of course, that that third category of overhead. And again, overhead might be split in a traditional sense, into a couple or three different pools. Those pools are then assigned to products based on an estimation process. Well one change as we move from a traditional system to an activity-based costing system is that we don't necessarily have to think about the product but rather the cost object. We'll see an advantage of activity-based costing a bit later, and that is you can adopt whatever perspective of whatever you care about the cost of via this system. So, we've shifted from a product focus to a more generic cost object focus. And examples of cost objects would be, the product that we produced, that's certainly still there, but it might be a department or division, or perhaps a particular employee and we care about understanding what the cost of that resource to the organization is. We can use activity-based costing, to essentially turn the view however we need it, to see what the cost of the thing that we care about it is. Another way in which activity based costing differs from a traditional costing system, is in it's variety and expansion. So again we start with what we originally called overhead costs. And we think about how those overhead costs are used up by activities that are performed by the managers and employees inside of the organization. Now imagine that you have a job to list all of the activities that you engaged in throughout the day. Now you're just one person, and this is just one day. But I imagine that that list would be quite long. Now take that task and do it inside of an organization with many different managers and employees, all performing different rules and responsibilities. You could imagine that list would be immense. So while I can't show it necessarily on the screen looking horizontally from activity one, all the way to the right to activity number n. And we're talking potentially hundreds and thousands of different activities that we've identified and care about inside of the normal organization. Next is the grouping process. And we would identify different activities and how they roll up into different pools. Sometimes multiple activities can be included in the same pool or each activity might have its own pool. It depends on the needs of the decision makers and how refined we'd like to get with this type of system. But again, we have a list of different activity pools much more involved and much longer than what we would see in a simplified, traditional costing system. And then the last step is to assign these different activity pools, all measured in terms of cost to the cost object. So whatever the cost object is using in terms of these activities, that's how we determine what its cost is. Now, let's have a checkpoint, just to make sure we're all on the same page. So let's think about some of the advantages of activity-based costing systems. And there are plenty. The first and foremost is the intent to achieve more accurate cost information. We're not smoothing overhead over products on an estimation basis. We're actually looking at how each cost object is consuming resource via the specific activities. And those activities are represented by the incurrence of costs. As mentioned earlier, these systems also have more flexibility, and that's another advantage, we can look at the firm however we want to, we can define whatever cost object we would like, and identify the cost of those objects, it extends the systems usefulness beyond just a product base focus. Now these advantages don't come for free, there are major disadvantages to activity-based costing. One, is the implementation, as I mentioned before listing out the activities of all the managers and employees is quite a lengthy process and understanding how those activities consume resources is very difficult in many situations. Just given the complexity of various organizations. A second disadvantage is the maintenance. Imagine if a new employee was hired or roles and responsibilities were shifted around, well then that changes the list of activities that each individual does and that the system needs to change in accordance with that. So, in many situations, the advantages of activity-based costing are not worth the disadvantages especially in highly changing environments, where products are coming in and out of the firm or activities are changing quite substantially. Keeping the system up with those changes sometimes yields too many costs that don't achieve the benefits that are intended. But, in many cases, activity-based costing provides more accurate cost information and is a more flexible view of the firm. And in those situations, activity-based costing just may be worth it.
