What are the advantages and disadvantages of the step-down method of activity-based costing relative to the step-down method of cost allocation?
The correct answer and explanation is:
The step-down method of activity-based costing (ABC) and the step-down method of cost allocation both aim to allocate indirect costs to cost objects, but they differ in their methodology and scope. Here’s a breakdown of their advantages and disadvantages:
Advantages of Step-Down Method of Activity-Based Costing:
- Improved Accuracy: ABC allocates costs based on activities and their consumption, leading to more precise cost assignment.
- Better Cost Insights: Provides managers with detailed information on cost drivers, enabling better decision-making.
- Facilitates Strategic Decisions: Useful for identifying high-cost activities and opportunities for process improvements.
- Supports Product and Customer Profitability Analysis: ABC helps in understanding the true profitability of products, services, or customers.
Disadvantages of Step-Down Method of Activity-Based Costing:
- Complex and Time-Consuming: ABC requires detailed data collection and analysis, increasing implementation and maintenance efforts.
- Higher Cost: The system requires significant resources and expertise to set up and operate.
- Subjectivity in Allocation: Selecting cost drivers and activities involves judgment, which may introduce bias.
- Not Ideal for All Businesses: For companies with fewer indirect costs or simpler operations, the benefits may not outweigh the costs.
Advantages of Step-Down Method of Cost Allocation:
- Simpler and Faster: Relatively straightforward compared to ABC, making it easier to implement.
- Lower Cost: Requires less data and fewer resources, reducing implementation costs.
- Widely Used: Established and familiar method, especially in traditional cost systems.
Disadvantages of Step-Down Method of Cost Allocation:
- Less Accurate: Allocates costs based on service department interactions, not activities, leading to potential inaccuracies.
- Ignores Secondary Allocations: Once costs are allocated, they are not reassigned, which can overlook inter-departmental service exchanges.
- Limited Decision-Making Support: Provides less granular insights into cost drivers, making it less effective for strategic decisions.
In conclusion, the step-down method of ABC is more accurate and insightful but resource-intensive, while the step-down method of cost allocation is simpler and cost-effective but less precise and less informative. The choice between the two depends on organizational needs and complexity.