An activity-based costing system has the following advantages:

• Accurate product cost and product and customer profitability measurement: An ABC system provides accurate and detailed product information that can be utilized by management in decision-making process. It can help to make better-informed management decisions concerning product pricing, product volumes, market segments, product lines, and target costing.
• Better-informed strategic decisions: The information about cost drivers for each activity enables management to make better-informed decisions concerning product design, customer support, etc.
• Production improvement: An ABC system provides information helpful in improving production processes.
• Better product cost information: An ABC system provides a lot of information necessary for strategic budgeting, planning, and product pricing decisions. It also takes into consideration cost of unused capacity and measures it at all levels (i.e. product, batch, and facility-levels).

In activity-based costing:

• Both manufacturing and nonmanufacturing (period) costs could be allocated to products.
• Some manufacturing costs that are not related to product costs can be excluded from product costs.
• Activity cost drivers (or overhead rates) can be based on the level of activity at the factory’s capacity rather than on the budgeted level of production. In other words, products are not assigned the cost of idle capacity, which results in a more stable unit cost. Idle capacity costs, in this case, are treated as period costs (i.e. an expense on income statement) and thus are not buried in inventory costs (i.e. cost of goods sold).
• There are multiple specific cost drivers that are more accurate than a single plant-wide rate or multiple department overhead rates, which are used in volume-based costing (see illustration below).

Illustration 2: Overhead rates in activity-based costing

Though an ABC system has many benefits and advantages, it fails to properly include all product-related costs and fails to allocate the cost activities with ambiguous cost drivers. Many general costs, such as marketing, research and development, and engineering, are not included into an ABC system since they are classified as period costs (i.e. not product costs) according to GAAP (generally accepted accounting principles). For some activities, also, it is either impossible or unreasonable to try to identify a cost driver, and it is often better to use a volume-based cost system in that case. For example, it is better to allocate factory property taxes (i.e. factory overhead) using a volume-based cost driver (e.g. square-footage). The same will be true for a factory’s manager salary, factory insurance, etc.

Now, when we have compared volume-based and activity-based costing and have determined the benefits of ABC, we can examine three steps in developing an ABC system.