Conditions under which activity-based cost systems provide relevant costs.

Abstract

Abstract Activity-Based Cost systems assign costs to products on the basis of multiple "cost drivers," which may or may not be proportional to the volume of output. This is in contrast to most traditional cost systems which use only one allocation basis (usually direct labor or machine hours) that is proportional to volume. Commonly cited reasons for switching to Activity-Based Cost systems are to more accurately estimate product profitability for purposes of making product pricing and drop decisions and to reduce the cost of manufacturing products in the design stage by providing more accurate cost information concerning alternative design specifications. In this paper the conditions under which an Activity-Based Cost system would provide relevant information for just such decisions are derived. These conditions are quite stringent and include, among other things, that all costs must be strictly proportional to their "cost drivers."