Activity-Based Costing in the Education Sector - Essay Example

Activity-Based Costing in the Education Sector Activity-Based Costing in the Education Sector Introduction There are different costing methods suggested by the cost accounting systems to estimate the cost of goods manufactured or cost of services given by service providers. Among those costing systems, Activity-Based Costing (ABC) is the most commonly used method of cost accounting. ABC is based on the concept that every output needs certain activities, and each activity needs certain sources (Kaplan & Steven, 2013; Garrett, 2014; Bhimani & Bromwic, 2009). It follows a two-step process through which cost of resources is assigned to activities in the first step, and in the later step, it relates the activity cost to the output. For instance, if a teacher is giving lectures to ten different classes and he or she is paid fixed hourly charges then each class would be assigned a cost based on the time spent by the teacher in that particular class (Chartered Institute of Management Accountants, 2014; The Economist, 2009). This paper aims to discuss the process of ABC costing with the help of a detailed example, which can be used by the education sector organisations to estimate cost of services. In addition to this, internal efficiency, profitability, and quality of products have also been evaluated with reference to ABC. Activity-Based Costing Vs. Job Order Costing In contrast to ABC, there is another costing system, which is used generally, called job order costing. In this costing system, cost of the job is determined by allocating the certain percentage of the cost incurred to the job in process rather than focusing on determining the cost per unit (Heisinger, 2009; Ingram, 2014). For instance, a teacher is giving lectures in ten classes; job order costing system requires accumulating labour and other direct cost incurred by the organisation in ten classes instead of looking at cost of each class separately. Job order costing is a traditional method, which does not facilitate management in decision-making (Kinney & Raiborn, 2012; Needles, 2013). Activity-Based Costing in Education Industry Activity based costing provides management with the decision-making information, which was not possible with the use of traditional costing methods. ABC method focuses on the product cost rather than focusing in the cost that does not have any relationship with the product. There are basically six steps that can be used to produce the product cost for education industry (Scarlett, 2009; Rouse, 2011). These are mentioned below, (1) Activity Identification In this step, activities are identified and gathered into activity pools. Activity pools include all related activities that are involved in the production of service. These activity pools may include costs that are assigned to supporting activities in individual products. (2) Activity Analysis This is the second step in the activity based costing which clearly identifies the integral processes that are supporting the production of a service. In addition to this, some of the inaccuracies of the traditional costing are avoided in this step. This activity analysis is similar to process mapping involve in lean manufacturing. With the help of the activity analysis, indirect cost relationships are identified and it allows some of the portion of the indirect cost to be included in the end product. (3) Cost Allocation On the basis of overall activity carried out in step one and step two, all costs are assigned to an activity pool. For example, managerial cost would be included in indirect administrative cost. These pools would finally contribute towards the overall cost. (4) Calculate Activity Rate In this step of Activity-Based Costing, activity rates are calculated, for example, initial analysis may include indirect labour hours or direct labour hours. These activities must be given a real value in currency and all the weightings are added in this step. (5) Assign Cost to Cost Objective As soon as the activity costs, rates and pools are identified and defined clearly, they are assigned to cost objectives. The results that are offered to clients are referred as objects. In both service and manufacturing industry these objects should have some value in comparison to assigned cost. (6) Prepare and Distribute Management Reports Once the Activity-Based Analysis is completed all the information related to cost components should be should be placed together in a proper manner for process owners and cost objects. It very important to communicate the whole costing analysis wit the concerned management because of the huge cost involved in this. ABC in Education Sector: A practical Example To explain the above-mentioned process, an example of university student service department would be useful. Mentioned below is an example that is clearly mentioning the activity centre, activity, and activity classification. Student Service Department Activity Centre Activity Activity Classification International Student Division Visa arrangements/ permits Batch Student Affair Division College social activities Career placement Personal counselling Graduation Orientation week (Chea, 2011) Units Admission and Enrolment Division Registration with university, college Record maintenance Unit Batch Housing Division Arrangement of accommodation within campus area as well as outside Unit Examination Division Semester results Examination process and procedures Invigilator’s duties Unit examination Unit Batch Batch Batch Batch The next step is to develop cost assignment model for college/university using ABC costing method. This model would consist of the following, Resources All economic elements, which are required to initiate activities. Activity Centre A group of similar activities. Resources drivers The factor that are supposed to be used to assign resources or cost pools to activities (Chartered Institute of Management Accountants, 2014; Emblemsvag, 2010) . Activity cost pool Aggregate cost assign to an activity Cost driver It is a factor used to allocate cost from a centre of activity to object of cost (Heisinger, 2009; CIMA Global, 2014). Cost Elements The expenses incurrent to obtain a resource and allocated to an activity. Cost Object This is ultimate objective to perform an activity, and in Activity-Based Costing this factors represent the total cost assigned to a service (Oregon State University, 2014; Institute of Management Accountants, 2006). An important task in the ABC costing method is to analyse and identify the drivers. There are basically two types of drivers. Resource Drivers Activity/ Cost Drivers Resource drivers establish link between resources and activities (Mowen, 2011). For instance, resource drivers may allocate the overall budget of the registrar office to each resource centre, which is student service department. Division Resource Driver Resource Centre Activity Centre Activity pool Cost Elements Cost Drivers ABC Process (Chea, 2011) As discussed earlier that ABC converts the total cost into units cost to facilitate the decision making process. This picture also illustrates that the total cost of the student services department has five sub components and they have their relative cost. Cost per student has to be computed in each 5 component and the aggregated cost would be the total cost per student. Let’s imagine there are 1,000 students and following cost would be incurred in the student service department. Activity Centre Cost ($) Student Affair Department 50,000 International Division 40,000 Housing division 80,000 Examination Division 20000 Admin and Enrolment division 30,000 Total cost for all activities is $ 220,000 for 1000 student. Per student cost of student service department is $220. With the help of this detailed example, it is clear that implementation of ABC costing method in small education sector organisation is not a very difficult task. The most significant work in the whole process is to gather the information regarding the cost elements and their triggers. Although, information gathering is a lengthy process, but the benefit associated with the use of ABC would surely be greater than its cost. (B) Benefit of ABC Costing for Evaluation of Internal Efficiencies ABC Costing allocates the costs of production on the basis of the cost drivers. As the company allocates the costs on the basis of costs drivers, it becomes easier to identify the areas, which are consuming more costs (Weygandt et al., 2009). For instance, increase in entertainment expenses may be because of more consumption by teachers in the educational institution rather than the guests and other staff; such identification will help in curtailing the expenses on teachers’ consumption. ABC costing also assists in identifying the costs drivers, which leads to identification of hidden cost drivers. In line with the practices of the organisations, the persons responsible for the consumption of the costs might be questioned as to why cost consumption is exceeding the budgeted limits (Kenneth, 2013; Kaplan UK, 2012). Such questioning and arguments by the respondents may help in identifying the new cost drivers, which were not identified earlier. For example normal users of the hostel utilities are primarily students, but detailed investigation might reveal that the night shift of housekeeping department of the hostel is consuming the costs also. Introduction of new cost drivers will help in better-cost allocation and consequently improve better pricing of the fees and subscriptions of the students. ABC Costing helps to identify the cost activities that constitute substantial part of the total costs. Such identification will direct the management efforts to reduce the costs for those activities, which will assist in reducing the costs of operations. Moreover if ABC Costing is benchmarked then it can assist in comparing the costs per activity with the costs of competitors. Similarly, such benchmarking will assist in comparing the costs per activity of two similar activities of the institute (Robert & Steven, 2009; CIMA Global, 2008). This will bring more internal efficiencies in the production because if costs consumption is more than the items benchmarked, then further studies will be conducted in order to identify the reason for efficient consumption. Such techniques that are responsible for efficient consumption will be applied accordingly. Benefit of ABC Costing for Evaluation of Profitability ABC costing is useful in assessing and increasing the profitability of the companies and products. Normally, increasing the revenues and decreasing the costs increase profits. For reducing the costs, it is essential to identify the components of the costs, which are consuming costs. Such break-up of the total costs will then lead to targeted efforts for cost reduction. Each and every activity will be worked upon individually and results will be monitored so that costs are controlled (Don & Maryanne, 2011). Activity based costing is unique for cost controlling because it does not divide the costs on simple percentage methods; rather it allocates the cost on the basis of cost drivers. For example, a teacher teaches 10 hours to elementary level and 12 hours to advanced level. Both the levels have 50 students in the classroom. The remuneration paid to teacher is $ 1000. As per conventional method, the cost of lecture per student will be $ 10 (total remuneration divided by total number of students). However, as per ABC costing the cost per student will be $ 9 / student of elementary level and $ 11 per student of advanced level ((total remuneration / total hours taught) x (total hours taught to advanced level/ 50 students)). ABC costing has changed the results as compared to simple costs allocation methods. This is the main reason why ABC Costing is preferred for profitability assessments. ABC Costing eliminates the irrelevant costs that were earlier allocated to the products. Normally overheads and other expenses are allocated to all the products and services. Since ABC Costing allocates the costs on the basis of activity cost drivers, the costs that pertain to only those products or services are allocated to them (Kurt, 2010; Wilkinson, 2013). Benefit of ABC Costing for Enhancing Quality Since entities start getting control of the costs by ABC Costing, more attention is diverted towards customer satisfaction and quality assurance. Costs savings makes more funds available for enhancing quality, which then leads to increase in sales and profits further. Quality is not a step of production, which if incorporated in the production cycle can improve the performance of the product or service; it is actually an attribute that runs parallel to all the steps of the production. If quality is ignored from any step of the operation, it will hurt the overall quality of the product. This is the main reason why ABC Costing is helpful for enhancing quality because ABC costing divides the production cycle in different activities. This process assists in monitoring quality at each activity so that overall quality can be delivered (James, 2010; Scheid, 2011). Disadvantages of ABC Costing System Despite the advantages of the ABC Costing mentioned above, it has substantial demerits also. Following are the main drawbacks of the ABC Costing system: ABC Costing works on the principles of cost drivers, which require resources to identify the costs drivers. Identification of the cost drivers is a difficult process that demands detailed investigation of the activities so that the costs drivers can be ascertained with precision. For example, in an educational institution it is difficult to establish as to which section of students is adding to the expenses of library costs, moreover; are these costs being consumed by students, teachers or researchers (Mathew, 2010; Hall, 2012). ABC Costing is difficult to be applied to overheads because it is not easy to identify the cost drivers for all of the overheads. Overheads are difficult to be related to all the activities that are responsible for its consumption. For example, staff, students, lecturers and visitors use an educational campus building also. It is difficult to ascertain the consumption ratio of the expenses like building repairs and maintenance for all the cost drivers (Wholey et al., 2010; Mitra, 2009). ABC Costing is not feasible for small entities because the costs that are incurred for implementing ABC Costing will be more than the benefits availed from it. The costs for implementing ABC costing includes the research and study expenses for identification of cost drivers, costs for training the employees for continuing with ABC Costing and the time served for change management from previous traditional costing techniques to ABC Costing system. All these costs are significant for decision-making and can bring benefits to the entity only in the long-run (Judith, 2010; Jain, 2010; Koontz, 2009). Normally, ABC Costing is difficult to be illustrated to the users (Black & Al-Kilani, 2013). This problem exists in educational institutions also where deans and other decision makers are experts of their relevant fields. They are not aware of even the basic accounting terminologies. It is difficult for them to understand words like cost drivers. Moreover, the application of cost drivers for cost allocation is even more difficult to be understood (Dyson, 2007). Another disadvantage of the ABC Costing is that it has introduced many cost pools in the costing mechanisms. Earlier in traditional costing techniques, the costs were mainly broken into fewer categories such as materials, labour, overheads and other such significant heads (Coulter, 2012). Activity Based Costing has changed this trend; there are more cost drivers and more cost activities in ABC Costing, which makes it complex to understand. For example, previously there was a stationary expense in the educational institutions; now there are classroom stationary and office stationary cost pools (Debarshi, 2011). 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