Which of the following is a limitation of activity-based costing?
A It can only be used to improve product costing.
B Only manufacturing companies can use it.
C It does not lead to better management decisions.
D Arbitrary allocations of overhead costs may continue
The correct answer and explanation is :
Correct Answer: D — Arbitrary allocations of overhead costs may continue
Explanation (300 words):
Activity-Based Costing (ABC) is a costing methodology that assigns overhead and indirect costs to related products and services by identifying cost-driving activities. While ABC is often praised for its accuracy in allocating overhead costs compared to traditional costing systems, it is not without limitations.
One significant limitation is that arbitrary allocations of overhead costs may still continue (Option D). Despite its more refined approach, ABC requires subjective judgment in selecting cost drivers and determining how much overhead each activity consumes. These choices can introduce arbitrary elements, especially when estimating how resources are consumed by multiple activities. When cost drivers are not truly reflective of resource usage or are too broadly defined, allocations can still be inaccurate or misleading.
Let’s consider the other options to clarify why they are incorrect:
- A. It can only be used to improve product costing: This is false. ABC is useful not just for product costing but also for improving business processes, customer profitability analysis, and strategic decision-making.
- B. Only manufacturing companies can use it: This is not true. ABC can be applied in service industries, healthcare, education, and more. Any organization with indirect costs and complex operations can benefit from it.
- C. It does not lead to better management decisions: Incorrect. ABC typically enhances decision-making by providing more accurate cost information, leading to better pricing, budgeting, and process improvements.
In summary, although ABC offers a more nuanced way to assign overhead costs, it’s not immune to subjectivity and estimation errors, which can result in continued arbitrary allocations. This undermines the system’s precision, especially when not carefully implemented or regularly updated. Organizations must be cautious and thoughtful when selecting cost drivers and setting up their ABC systems.