The Activity Based Costing System - Assignment Example

? Accounting for decision making Contents Contents 2 Introduction 3 Effectiveness of Traditional and Activity Based costing system 7 Effectiveness ofTraditional Based costing system 7 Effectiveness of Activity Based Costing 10 Conclusion 13 References 14 Introduction Costing systems are types of information systems which require a particular type of information like the number of units produced and the number of direct labour hours of value that are involved in the process. These data are put as input into the costing system and the specific methodology of the costing system is used to produce information like the cost of the product and other important information as the output. The same data for input may be used differently according to different methodologies of the costing information system which may result in the production of varying outputs of information. A costing system is aimed at generating information to find ways to minimize waste in production. It should be taken care of that the benefits that are derived from the costing system should be higher than the resources used in designing, implementing and maintaining the costing system so that wastage is minimized. It is important to understand the fundamental working of the two systems i.e. The Traditional Costing System and the Activity Based Costing System in order make a comparison between the two. The traditional costing system The traditional costing systems use a single cost driver which is based on volume. Due to this reason, the traditional costing systems tend to distort the cost of the products. Also, this type of costing system allocates the overhead cost to the product based on the comparative usage of direct labour. Due to these drawbacks, the traditional cost systems might often produce a result containing inaccurate costs of product. The methodology underlying the traditional costing system is that it assumes that products would definitely cause cost and that each time a product unit is manufactured, a certain cost is incurred in the process. This methodology has certain drawbacks including the fact that although it rightly accounts for the direct costs, it does not apply to indirect activities performed in the product unit. Therefore for the overhead activities, the correct proportion of activity actually used for a specific unit of product is not exactly corresponding with one single cost driver (Akyol, 2012, p. 64). The conventional cost accounting system uses a volume based driver like the number of machine hours or the number of direct labour hours for assigning all the overhead costs incurred in the manufacturing process. But in almost all modern companies, the production process uses a combination of technology and manpower thus incurring overhead costs for both. But in the traditional costing model, the cost of goods sold is based on absorption costing and includes only the product costs as described in financial accounting. Therefore, the traditional costing model assigns the costs directly to the products before assigning costs to the activities involved in producing the product units first. The results generated thus a report about the information on the amounts spent on the product units but they do not give the reason as to why they are spent. This costing system is based on the application of costs to indirect cost drivers and the indirect costs are generally based on financial cost drivers. The traditional costing model uses a system in which the total costs incurred in the production is divided among the different products thus produced. Therefore, all the costs incurred in the production process have to be allocated to one or another product. The traditional costing model has the disadvantage that if overhead costs are cut down for reducing the total costs, only the signs of high cost are treated and the cause behind the higher costs remain unaltered. Also, the reduction of overheads is likely to result in the reduction of the quality of the products rather than in long term decrease in the cost incurred in production (Zeuner, 2012, p.27). For segmented reporting of the production costs, it is important to separate the fixed costs and the traceable costs because fixed costs are booked in the traditional costing model and traceable costs are pooled in different departments. A general and comprehensive guideline is used in traditional costing model to determine the traceable costs separately. But these guidelines are known to have certain inadequacies as mentioned earlier. The Activity Based Costing (ABC) System The methodology underlying activity based costing is completely different from the traditional based costing. The conventional costing model is based on the assumption that the costs are caused by products whereas the activity based control model assumes that the fundamental cost objects are activities. The activity based costing model also assumes that cost objects drive the demand for activities. The activity based costing is a different approach from the traditional costing model and it improves on the control of overheads by accost-activity relationship. The activity based model is a flexible model which relates all the costs like cost of products, cost of processors, cost of management and costs of customers. It is a system which focuses on the activities being the basic cost drivers and it uses these activity costs to compile the costs of the other cost objects involved in the process. An activity based model helps a company to develop new methods of studying, analyzing, justifying as well as improving the production life cycle process. The use of activity based costing has evolved through years from an accurate model of product costing, to a more analytic method of advanced planning, cost reduction, encompassing activity based costing, activity-based budgeting, activity reporting, continuous improvement, performance measurement and benchmarking, activity based cost management, product/customer and sector profitability and Business process re-engineering (BPE). Thus in activity based model focus is on costs being assigned to activities rather than to units of products manufactured. This model of costing is more critical on the issue consumption of resources utilized. This model also makes sure that the managers keep a close eye on the fixed costs thereby helping management identify the probable domains of inefficiency and identifying the costs may have been conceived as fixed costs but which in reality are variable costs or semi variable costs according to particular products. The activity based model is aimed to reduce the issues of cost distortion often faced by the traditional costing model. Activity based costing, activity grouping, cost driver analysis and performance evaluation should be part of the performance improvement techniques. Activity based costing model gives a financial dimension to a wide management process. This model is used for process improvement, benchmarking, process re-engineering, highlighting wastage and secondary support activities (Roychowdhury, 2011, p.12). In utilizing activity based costing, and costs are collected for each activity as an independent cost object. These costs are then applied to commodities as they undergo the different activities. The final product cost is built up from the costs of the specific activities that each product line has undergone. In other words activity based costing allocates activity costs to matter based on activity drivers that precisely measures utilization of the activity. When utilizing the activity based costing system managers attempt to assign the costs of significant actions to the products that causes those costs to be incurred. This consequences in activity based costing providing enough information to allow managers to be acquainted with which activities cause the exercise of resources. Activity based costing is used to track the various activity costs to cost objects which projects, may be products, services, customers, projects and distribution channels. In an activity based costing system, first an activity analysis is done followed by activity based costing. Then the overhead costs are assigned to a large number of cost pools that represent the most significant activities involved in the production process. It is also proper to mention that activity based costing systems make use of numerous indirect cost pools because of the many activity areas. The suitable cost drivers are identified for each cost pool after all the costs have been segregated into different activity cost pools. After that, the overhead costs are mapped from one activity cost pool to one production job in proportion to the quantity of activity needed to complete the job. So this costing model maps costs to cost objects on the basis of activity drivers which are used to measure the exact consumption of the activity (Bradtke, 2007, p.131).The accuracy of product costing in this model is derived from the identification of a huge number of activity cost pools and the separation of a specific cost driver for each of the activities. The main point in this costing model is on resources and the activities that cause these resources and there is no separation between the product and the period costs as defined in financial accounting. The classification of activities should include some value added analysis and all the staff who is involved in classifying these activities should understand the definitions clearly. A value added activity is any activity that cannot be eliminated without being detrimental for the final production. Though the activity based modelling is subjective, it is a more effective model used for performance improvement. The popular definition of a non-value added activity is anything that can be eliminated without detriment to the final product. Although activity classification is subjective, it is only a tool to help with performance improvement (Richards, 2011, p.75). Effectiveness of Traditional and Activity Based costing system Costing systems are basically information systems. They need certain specific type of information like direct labour hours and units produced to use them to calculate the cost. With this data the product costs and other key information are determined according to the costing system techniques. But each costing system has own costing techniques to arrive at the result. We here discuss the effectiveness in using both the Traditional costing system and Activity based costing system. Basically every costing system should minimize the waste, i.e. the resources that are required to implement the costing system should be less than the benefit which it derives out of using that technique (Dhillon, 2013, p. 45). Effectiveness of Traditional Based costing system In traditional based costing system only a single, volume-based cost driver is used. That is the overhead cost is assumed to be influenced by the units produced only. It means that here cost of batch level, product level and the facility level activities do not vary with the production volume. In such Unit-based costing system it considers fixed overhead to the individual products and a variable overhead are considered for products based on the number of units produced. But in reality there are many inputs to the factory overhead like machine setups, special handling, special storage, unique inspections and so on. The more diverse the product gets, the process of allocating the costs to the various activities gets problematic (Baker, 1998, p. 45). When fixed cost are given on the basis of the number of units made, such technique is an arbitrary way to assign cost and hence it may not reflect the activities and the cost actually consumed by the products. Here the indirect costs to the products are based on a predetermined overhead rate. Such costing systems treat costs as a single pool of indirect costs. Hence traditional costing is optimal only when the indirect cost associated with it is low as compared to the direct cost. There are several steps in the costing of traditional based costing system like 1. Identifying the indirect costs. 2. Estimating the indirect costs for the period in consideration 3. Choosing a cost-driver for the cost like labour hours and machine hours. 4. Estimating the amount for the period under consideration like labour hours per quarter, machine hour 5. Computing the predetermined overhead rate 6. Applying the overhead calculated to the products using the predetermined overhead rate. Predetermined Overhead Rate = Estimated Overhead Costs / Estimated Cost Driver Amount. Easy to Apply Traditional Costing system is relatively easy to apply. It is easy for the managers to find the direct cost which is associated with a product, along with a labour and direct material costs. It is tricky to assign the overhead costs to the different products. In a manufacturing environment to assign overhead costs. Direct labour is a simple way to achieve it. At the time traditional costing system was developed, direct labour was the biggest cost associated with a production. Hence it was used as a proxy in allocating the overheads, with the manager’s allocating higher overheads to the products which have higher direct labour hours (Lewis, 1995, p. 22). Ability to Distort Traditional costing is a good technique to use for a business which manufactures large volume of few products. But as the business starts to manufactures large volume of large products which means as the level of diversity in products starts to increase, then traditional costing starts to become less reliable. Hence for firms which have a lot of overhead expenses to looks at need a more reliable method to allocate the overhead cost to the different products. It is an important factor for the firms to take into consideration because if they incorrect costing method to allocate the costs, then the firms may price their products incorrectly which can affect their revenue considerably and hence their competitive position might get affected (Cokins, 2002, p. 69). Outdated Traditional costing methods were developed when there were no computers. Nowadays Machines and computers are used in the production process. Hence this had led to decreased need for labour in the manufacturing process. So a system which uses directs labour to allocate different overheads in an outdated one. Figure 1: Traditional Based Costing Effectiveness of Activity Based Costing Activity based costing is an improvement over the traditional costing because this process recognises the fact that many fixed overhead costs varies in proportion to the changes in the production level. In ABC the two level activities batch level and the product level activities are assumed to influence the fixed overhead costs, batch level and product level. Hence it is recognised as non-unit-based cost drivers. Then by establishing the link between the cost drivers and the fixed overhead costs it is finally traced to the individual products. Figure 2: Activity Based Costing ABC brings more accuracy and reliability in the product cost determination of the products by focusing on the cause of the cost incurrence. It accepts the fact that it is the activities which cause costs and the products which consumes the cost. In advanced technological and manufacturing environment ABC gives a more realistic because here overheads form a large share in the product costs. ABC helps in reducing the cost by identifying activities which do not add value to the product. Hence the real cost behaviour can be easily identified. By having more control over the activities which caused these fixed overhead costs, managers are better able to control the fixed overhead cost. It is possible as the behaviour of the fixed overhead costs with relation to the activities has now become more visible and clears (Leitner, 2007, p. 87). ABC uses many cost drivers which are transaction based instead of being product volume based. Also ABC is concerned with all activities which are beyond the factory work so that it can trace more overheads to the products. ABC uses the cost from all areas like managerial responsibility, customers, processes etc. besides the normal product costs. ABC improves the decision making ability of the manager as they can use more reliable product cost data. ABC helps in fixing the selling prices of the products. In forms where there is more diversity in products like producing low-volume products or low-volume products, ABS gives more reliable product cost data. In cost management and performance appraisal, ABC provides cost driver rates which are important for it. It not only calculates more accurate product costs but also provides a mechanism for managing costs. An ABC approach focuses the attention of the management on the underlying cause of the costs. It is based on the premise that the resource-consuming activities cause the costs and that the products incur costs through various activities like designing, engineering, marketing, delivery, servicing and invoicing. Hence by understanding the significant activities which a business engages in, it is possible to manage the cost more effectively. But still there are many demerits of ABC approach. ABC approach can be more complex than the traditional product costing approach because it involves multiple cost drivers. Selection of cost drivers, varying the cost driver rates, assignment of common costs etc. are some of the difficulties which ABC faces. ABC is useful for firms that use cost-plus pricing strategy as it gives more accurate product cost. But for firms using market based pricing strategy ABC is not helpful. Managing the ABC system is costly as compared to traditional costing system. Conclusion The decision to use Traditional approach or ABC approach of cost accounting depends on the benefits of the system. Such decision depends on different factors like level of completion the firm faces, product diversity it manufactures, number of products manufactured. The companies who operate in competitive environment needs correct product cost data for taking sound decision regarding the price of the product and taking better cost management measures which can affect their profitability. ABC system gives more accurate cost and hence enables the managers to find the true cost of a product. However there should be internal control put in place to avoid any unauthorized users to make modification to the data in the system. It is true if ABC replaces any existing cost accounting system like the traditional accounting system. Most of the firms nowadays use ABC based cost system over traditional based cost system since most of the firms produce a variety of products in low volume which gives them diversity in their operation, which reduces their risk and profitability enhances. Also profitability under these two approaches is different with ABC approach giving more accurate profit result than the traditional approach. Though both cost based system are applicable for all firms to use but generally it is preferable to use ABC approach in today’s competitive environment. References Akyol, D. 2012. A comparative analysis of activity-based costing and traditional costing. [Pdf]. Available at: http://www.waset.org/journals/waset/v3/v3-98.pdf. Dhillon, B., 2013. Life Cycle Costing: Techniques, Models and Applications. New York: Routledge. Baker, J., 1998. Activity-based Costing and Activity-based Management for Health Care. Sudbury: Jones & Bartlett Learning. Lewis, R., 1995. Activity-based Models for Cost Management Systems. New York: Greenwood Publishing Group. Cokins, G., 2002. Activity-Based Cost Management: An Executive's Guide. New York: John Wiley & Sons. Roychowdhury, S. 2011. Cost Allocation. [Online]. Available at: http://ocw.mit.edu/courses/sloan-school-of-management/15-501-introduction-to-financial-and-managerial-accounting-. Zeuner, P. 2012. Activity-Based Costing. United States: GRIN Verlag. Bradtke, D. 2007. Activity-Based-Costing. United States: GRIN Verlag. Leitner, A. 2007. Activity Based costing. United States: GRIN Verlag. Read More