Activity Based Costing (ABC) addresses internal operating concerns and is an augmentation to the traditional cost management system. It is not a replacement for traditional accounting, but makes use of the source documents provided from standard job costing systems. ABC looks at a business unitÐ²Ð‚™s events as cost drivers and assigns all company resources and accumulated costs against those events in a time-phased sequence. Revenue tracking provides management with a different point of view on the profitability of products and services, providing insight into pricing. Middle management and technical performing organizations are involved in the line item reporting provided within the ABC system, enabling management to achieve more responsibility of reported information throughout all levels of the organization. ABC is being ostensible by the accounting industry as the wave of the future and is gaining broad acceptance within larger organizations. This system is intended to provide performing entities and management alike.
History of ABC
Activity Based Costing (ABC) is an approach to costing that considers the resources consumed by activities in order to create and deliver a product or service. It evolved in the mid-1980s to improve the allocation of manufacturing overhead costs to products, but it soon became apparent that activity-based costing systems could be expanded to include non-manufacturing costs (Langfield-Smith, Thorne & Hilton, 2004).
Review of ABC
Whereas the underlying assumption of a conventional costing system is simply that products cause costs, an activity based costing system assumes that cost objects (e.g. juice) creates the demand for activities (e.g. manufacturing), which in turn causes resources to be consumed (e.g. manufacturing time, outlet space, etc.) and causes costs. Cost objects are the reason for performing activities, and activities are the processes or procedures that cause work and create costs.
ABC analyses costs from the perception of the how much a particular activity costs, and the amount of resources consumed by the end product of the activity. Using activity based costing differs from traditional cost accounting in that the focus is on the activities that are required to produce an end product, rather than assuming that the volume of the end product is the only driver of costs.
A cost driver is a term used in activity-based costing. It simply refers to any activity that causes a cost. It can be anything from machine hours, labor hours, number of machine setups, or the number of parts in a product.
By understanding how resources are transformed into products or services, and by focusing on the cost of activities, ABC helps an organisation to obtain a greater understanding of how costs behave in their organisation and which activities create significant amounts of cost. Organisations can then begin to control their costs based on tangible activities rather than relatively uninformative general ledger or cost centre reports.
ABC is the assignment of costs from resources to activities and then from activities to cost objects:
ABC identifies the processes and activities involved in producing the cost object (e.g. fruit juice) and then cost these activities. The activities are cost by taking the traditional general ledger cost reports and determining an appropriate resource driver to assign the resource costs to the various activities. This involves accumulating costs that behave in a similar way into Ð²Ð‚?cost poolsÐ²Ð‚™ (e.g. salary costs, machinery costs), and then identifying appropriate resource drivers to assign the costs from the cost pools to the activities (e.g. % of manufacturing time, factory space, etc).
The next step in ABC is to assign the activity costs to products
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Traditional and activity based costing
Costing systems are nothing but the arrangements which provides data and information. A specific data is required by them like units produced and direct labor hours to be of value. The cost of products and other information are determines from the input data as per the particular costing system defined methodology. The final outcomes derived will be based upon the costing system employed, as there are numerous techniques in which the same input data can be used (Hoggett and Merlin, 2006). The present report compares and contrasts between two costing systems i.e. traditional costing and the activity based costing system.
The Traditional Costing SystemIt is a recognized fact that singular volume-based cost driver is used in the traditional costing systems. Because of this there occurs distortion of cost of products in the traditional product costing framework. In majority of the cases, this kind of costing method is used to allocate various kinds of overhead costs to the products (Atkinson and et.al., 2001). When a singular volume measure is used as an overall driver of cost, then the cause and effect criteria which is intended in cost allocation is seldom met. It furnishes a comparatively cheap as well as inexpensive means of fulfilling the financial reporting requirements. Hence, this is the reason that traditional costing methods generally report incorrect product costs (Marx, 2009).
The main problem lies in the approach which supports this system. They stick to the presumption that cost is based on the products. It is presumed that whenever a unit is produced some kind of cost is associated with the product. This supposition is functional for only few direct costs. However, this postulation becomes irrelevant for actions in which there is no production of any unit (Karolefski, 2004). The main loophole in this approach is that for majority of the overhead activities, there is no universally singular cost driver which can give information regarding amount of an activity really consumed. This is true for the present organizations as in them goods are manufactured by integrating technology with manpower. Volume-based driver such as machine hours or direct labor hours are used in the traditional model of cost accounting for assigning all the overhead costs related to the production of a unit. This framework is based on absorption costing make use of cost of goods sold (Banker and et.al., 2006).Basically in traditional costing model, costs are directly associated with number of units manufactured instead of firstly assigning cost of each action involved and then determining the unit cost. Therefore this framework tells about the entire amount that has been spent on the production of a unit and does not tell about the reason behind the particular spending (Özbayrak, Akgün and Türker, 2004). When any organization tries to reduce its overhead cost for cutting down the total costs, then it is the symptoms which are being treated and not the actual problem. In a number of situations, cutting down overheads is likely to result in the deterioration in product quality rather than in the long term diminution of cost (Hoggett and Merlin, 2006).The segregation of fixed and traceable costs is important when a segmented reporting of cost is being done. This is crucial as the traceable fixed costs are associated with different sections of the company whereas in the traditional model of costing regular fixed costs are sum up. The suggested guideline for using this approach is to evaluate the traceable costs. Evidently, there are many inherent inaccuracies in this approach (Atkinson and et.al., 2001). In traditional model there are limited pools of indirect costs for every section or the entire manufacturing unit. The different kind of costs in this system is generally based on an indirect cost driver which is normally financial based. This costing method mainly employs a framework wherein the total costs for producing a particular number of units are segregated amongst number of units. When traditional costing model is applied then it implies that all the costs which have been incurred need to be assigned to one or the other product (Drury, 2008).Tremendous alterations have been introduced in the service and manufacturing industries. There has been a reduction in the amount of direct labor usage and a substantial rise in total overhead costs. This method is inappropriate to be used in plant wide fixed overhead rates when there is an absence of correlation. In complex manufacturing processes there is a need for multiple allocation bases and for this a need for approach cropped up (Atkinson and et.al., 2001).
Activity Based Costing Method(ABC costing)
These days, fierce worldwide competition is compelling manufacturing organizations and services to become more flexible, highly automated and integrated for increasing their productivity at condensed cost. However, it is not possible to sustain this competitiveness in absence of an accurate mechanism for cost calculation. Therefore, activity based costing is an alternate approach to traditional costing system, which allocates costs to individual actions making use of more than one cost driver, and then assigns costs to product units on the basis of every unit’s usage of these actions. When several actions are used as cost driver then the risk related to distortion is reduced plus more precise cost information is obtained (Özbayrak, Akgün and Türker, 2004).
In the ABC framework, the overall cost of a product unit is equal to the cost of raw materials and total cost of all value added activities involved in its production. In simple terms, in ABC system models the resources of the company are used as per the activities performed and accordingly associates cost of all these actions to the outputs like customers, services and products. Every unit needs a range of actions like designing, engineering, purchase, production and quality check. All these activities consume resources of distinct categories for e.g. working time of a supervisor etc. Cost drivers are normally the measures of these activities which have been performed like the total quantity of units produced, number of orders requested, hours of machine time and labor hours etc (Hicks, 2002).
This approach enhances the control of overheads by means of a cause/cost relationship which are cost and activity. It is sufficiently flexible to associate costs to processors, consumers and top authority and not merely items. The usage of an ABC model can assist companies in developing a method to evaluate as well as justify manufacturing cycle time improvements. When making use of ABC model, top authorities tend to allocate the costs of important actions to items that are responsible behind the incurring of these costs. As a result of this, activity based costing provides adequate information to enable managers to be aware about the activities which are consuming resources (Daly, 2001).
The most general approaches of this costing system begin with analyzing an action, subsequently making use of ABC system to develop performance improvement concepts. Thus, ABC is used to track the activity costs of cost items. These cost items may take form of projects, services, products, distribution channels or customers (Ben-Arieh and Qian, 2003). When appropriately applied, ABC eliminates the problem related to cost distortion by creating a cost pool for every action which can be separated as a cost driver. Performance enhancement techniques include activity grouping, assessment of cost driver and performance measurement in addition to ABC. In ABC model, overhead costs are allocated to a big number of cost pools which symbolize the most crucial action included in the course of production (Kaplan and Anderson, 2007).As seen in the above diagram, in the first step, overhead costs are assigned to activity cost pools. In this simplified illustration, the organization has recognized four different activity cost pools i.e. purchasing, warehousing, machining as well as supervising. Once the costs are associated to these activity cost pools, organization employs cost drivers for determining the costs to be assigned to an individual products (in the above illustration either steering wheels or axels) based on the consumption of every activity by each product. For instance, if axles need more activity by purchase department, as calculated by the quantity of purchase requisitions, then more of the overhead cost arising from the purchase pool will be assigned to the axels. As the manufacturing operation of a product gets more complex, then it is likely to have more cost drivers and activities. If there is no or little connection between the consumption of overhead costs and the cost drivers then imprecise product costs become unavoidable (Weygandt, Kimmel and Kieso, 2009).
The effectiveness of each costing system
This form of costing is important in various ways. It has shown its expediency in successfully managing the accounting operations of the organizations. The main advantage of the traditional costing is that it can maintain the alignment with the common accounting principles. It could be more compatible for the companies in order to match with the old accounting practices (Amsler, Busby and Williams, 1993). It is also known as conventional method but still companies us this method of costing in their organization at a very scale. This technique of costing enables the organization to calculate the estimated cost of the production of one unit of each product. It can provide deep insight in order to calculate the cost of other factors also which have been used for the production process. It is more significant when manufacturing units are using the labor cost. If the production process involves the cost of labor then they can use traditional costing system in sequence to calculate the cost of workers (Rahman, Omar and Abidin, 2003). Other than this it is helpful for the organizations that use production cost as fixed cost. It provides Huge advantage if direct cost is high and directly associated with the overhead cost like material cost and unit cost. Traditional costing system is very much effective where the product line is not complex and company is dealing in one type of product (Capettini, Chow and McNamee, 1998).
Simplicity could be considered as the major advantage of traditional costing system. It is easy to calculate overhead rates and doesn’t demand high level of expertise. This feature of traditional costing makes it more popular among the companies. It is easy to understand the applications of this particular principle of accounting (Pierce and Brown, 2006). With the help of traditional costing system it is easy for organization to calculate all the direct cost which incurred during the production of the product or which is associated with the product. Through this company can identify the major areas they should pay more attention in order to improve their production (GunaseKaran, Marri and Yusuf, 1999).
Small organizations can’t afford the installation of ABC accounting system as it is more expensive and required high level of dexterity to be operated. Other accounting system needs experienced workforce which can cause high income cost for the company. Smaller firms and medium enterprise can also get privilege through this accounting system (Rivero and Emblemsvag, 2007). It is cheaper and cost effective then the other types of accounting system. It enables them to apply this in their organization. Hence these are the major advantage and benefits for the organization if they follow this accounting system. Although, traditional accounting system has become obsolete but still smaller organization can take the advantage of this accounting principle. It could be reliable source of calculating the cost that uses the single product line (Helberg, Galletly and Bicheno, 1994).
Activity Based Costing
Increased Competition forced organization to get rid of traditional costing system in order to increase their productivity by reducing their cost. This task is impossible to achieve without introducing the change in the cost estimation mechanism. Consequently the accounting experts find out the solution ad introduced the alternative. Earlier companies used the traditional cost accounting system but that has been overtaking by the ABC method (Sheu, Chen and Kovar, 2003). It has number of advantage and reasons which make it popular among the new organizational structure. The main advantage of activity based costing is that it provides the accurate cost of the production of product. It is easy to estimate the real cost associated with the production of product (Amsler, Busby and Williams, 1993). The organizational structure is continuously increasing now a days and companies are having different product line in their manufacturing units. It is not appreciable to use traditional costing system in order to identify the cost. They need more reliable method of calculating the overhead cost. If any company is using the wrong inappropriate techniques of costing then it can adversely affect their pricing strategy and they can lose their competitive edge and can create danger over the sustainability factor (Rahman, Omar and Abidin, 2003). Activity based costing provides real accounting solutions to the organizations.
Due to the increasing use of technology new alternatives of costing has emerged and that is activity based costing. Diversification in the products is another reason that why companies should this particular method over the traditional costing system. The uncountable benefits of activity based costing includes that it has the capability of categorizing the value added activity and non value added activity (Capettini, Chow and McNamee, 1998). Company can eliminate the non value added feature in order to improve their performance. ABC can provide the satisfactory answer of such questions like how much time is required for the completion of task, what process must be used to produce a product and most importantly it resolves the financial matters by providing the accurate cost of the production process. In this way the deep study of the ABC and its applicability can enhance the efficiency of the manufacturing unit (Pierce and Brown, 2006). It is helpful the better management on the ground of accounts and managing the finance. This tactic enable organization to improve their financial performance, as it can determine the cost more accurately. The other significance of ABC is as follows:
This technique successfully supports other activities of the organizations like TQM and JIT systems (Helberg, Galletly and Bicheno, 1994). Due to these features organization increase the use of ABC in their accounting operations. It integrates with other departments and provides useful information to them in order to create their strategies. An organization that has different product range and manufacture different type of products really needs ABC in their organization.
Additionally it is improving the budgeting practices of the organization (Sheu, Chen and Kovar, 2003). They are aware of their production requirements and accordingly they are formulating budget for them on the quarterly basis. Its effectiveness is not only important for the manufacturing units but also for the customers as it reduces the prices and cost of the product (Helberg, Galletly and Bicheno, 1994). Its applications helps in obtaining the sufficient information related to the decision making process and it helps in avoiding the confusion which can be arises in the production process. It facilitates in setting the benchmark in the field of accounting. Overall the calculation of production cost is the main advantage of activity based costing but this one feature has led towards the generation of other improved solutions (GunaseKaran, Marri and Yusuf, 1999).
The main benefit of ABC system is that it ensures more exact product costing. Below mentioned are the reasons why:
Though the ABC approach normally furnishes better product cost information as compared to traditional system of costing, there are certain limitations to it:
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