Activity-Based Costing Advantages & Disadvantages

I did a study for a die casting operation that allocated all costs based on machine hours, ignoring labor and set-up time. It was an in house operation and they made small runs for older outboard motors as "needed". As you might guess, they often had 15 hours of set up time for a one or two hour run - significantly understating costs of these inventory items.

At a large consumer manufacturing operation they allocated overhead, including depreciation based on labor hours. They spent a few million on a automated production line for a high volume product, significantly reducing labor hours. The results were allocating the depreciation costs of the new line to the lower volume products, overstating the costs of these products and understating the costs of the high volume product. The profitability based on margins was misstated.

I am a evangelist for ABC, though not the ABC of complexity. Douglas Hicks wrote a great book "Activity Based Costing" Making It Work For Small and Mid-Sized Companies" which is the best reference document I have read. I have often quoted a line from his first edition "It is better to be reasonably accurate than precisely wrong." I have seen costs calculated to multiple decimals, but the costs were wrong based on the simplistic allocation factor(s) used.

When I use to set up MRP systems, we created BOM's with average setup time built in. Each step also had an average work time.

Depending on the sophistication of the manufacturer, we either used a "standard" labor cost or a full-fledged labor application methodology. Either way, I think we lived up to that quote "It is better to be reasonably accurate than precisely wrong."