Activity Based Costing - GAAP and External Reports:

Since activity based costing (ABC) system generally provides more accurate product costs than traditional costing methods, why isn't it used for external reports?

Some companies do use activity based costing in their external reports, but most do not. There are a number of reasons for this. First, external reports are less detailed than internal reports prepared for decision making. On the external reports, Individual product costs are not reported. Cost of goods sold and inventory valuations are disclosed, but their is no breakdown of these accounts by product. If some products are under-costed and some are over-costed, the errors tend to cancel each other when the product costs are added together.

Second, it is often very difficult to make changes in a company's accounting system. The official cost accounting system in most large companies are usually embedded in complex computer programs that have been modified in-house over the course of many years. It is extremely difficult to make changes in such computer programs without causing numerous bugs.

Third, an ABC costing system  does not conform to generally accepted accounting principles (GAAP). Product cost computed for external reports purposes must include all of the manufacturing costs and only manufacturing costs; but in ABC system products costs exclude some manufacturing costs and include some non-manufacturing costs. It is possible to adjust the ABC data at the end of the period to conform to GAAP, but it requires more work.

Fourth, the auditors are likely to be uncomfortable with allocation that are based on interviews with the company's personnel. Such objective data can be easily manipulated by management to make earnings and other key variables look more favorable.

For all of these reasons, most companies confine their ABC efforts to special studies for management, and they do not attempt to integrate activity based costing into their formal cost accounting system.

 

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