Concepts of Activity Based Costing - Term Paper Example

Table of Contents Introduction 1 Conceptual Relevance of Activity Based Costing and Traditional Costing 3 Concepts of Activity Based Costing 3 Concepts of Traditional Costing 4 Compare and Contrast between ABC and Traditional Costing Methods 5 Evidences 8 Conclusion 10 References 11 Introduction The recent global competition compels the organizations to become more integrated, highly automated and flexible in order to reduce their cost and enhance the productivity. It cannot be possible to sustain the competitiveness devoid of an accurate cost mechanism and thus here lies the necessity of the cost accounting. Cost accounting is an inseparable part of accounting. It is concerned with cost ascertainment, cost control and cost reduction in a well organized manner. Similar to other major segments of accounting such as financial accounting and management accounting, importance of cost accounting is also increasing. Cost accounting is very important for any organization as it covers processes of recording, allocating and classifying the expenditures for identifying the cost of products or services for the sake of presentation of the required accounting information to the higher authority or to the management. The major areas that are dealt within the cost accounting are products, job order and processes among others. Previously scope of cost accounting was limited to the manufacturing unit, but now with the formulation and enhancement of the improved and advanced procedures, cost accounting has also been adopted by the service industries. It denotes the emergence of the cost accounting in the businesses. Considering this fact, it has been intended to highlight the methods of the costing. More specifically, it can be stated that the paper will explain the two most commonly used costing methods in accounting and will contrast and compare them. Evidences reveal that the two commonly used cost accounting methods are activity based costing (ABC) and traditional costing. Hence, these two methods will be compared and contrasted in this paper. Conceptual Relevance of Activity Based Costing and Traditional Costing Before critically analyzing, the two concepts in terms of its comparison and contrast, it is important to develop the basic knowledge regarding both the concepts. Activity based costing method is comparatively newer to the industry. Hence, it has been intended to emphasize the concept to concrete the base of the discussion. Concepts of Activity Based Costing ABC is an economic model and determines the activity centers or cost pools in an organization. It allocates cost to the cost drivers that have been based upon the number of each activity adopted. The activities that generate cost need to be determined and matched to the level of drivers while using activity based costing. Though the cost drivers are linked with the activities, those can occur in the different phases. The unit level drivers assume the enhancement of the inputs for every produced unit. Secondly, the batch level drivers assume the ‘variation of the inputs’ in the every produced batch. Product level drivers presume the importance of the inputs to backup the production of different categories of the product. Finally, facility level drivers are associated with the manufacturing process of the facility. The users of the ABC methods need to follow the steps to determine the activities that generate cost (Akyol, D. E. & Et. Al, “Activity Based Costing”). Concepts of Traditional Costing The traditional approach of costing consisted of three initial aspects: basic cost of production, production and non-production department and final products and services. The steps that have been followed by this method are accumulation of costs from the non-production and production departments, allocation of the costs of non-production departments to the production departments and lastly allocating the cost of production department to the several products and services of the organization. For the management decision making purpose, this cost may not prove to be fruitful. The reason behind it is that the cost derived from the traditional costing method suffers from various errors and defects which can further results in the distorted costs. It can be better explained with an instance. The cost of the idle capacity has also been allocated to the products under the traditional costing methods. It implies that the products are charged for the resources that have not been used in the particular product. While seeking remedy from this kind of distortions, several companies have implemented different costing methods. Activity based costing is the most renowned among the alternative costing methods. In this point of discussion, it requires to demonstrate the differences and similarities of both the methods. Therefore, in the later stage traditional and activity based costing will be compared and contrasted. Compare and Contrast between ABC and Traditional Costing Methods The basic difference between the two methods is that traditional method is comparatively user-friendly than the activity based costing. To understand the other differences between these two concepts, the comparison can be demonstrated in a tabular format. Topic Traditional Costing Activity Based Costing Origin of the Concepts Based on the origin of the concepts, it has been found that traditional costing method was introduced between 1870 to 1920 On the other hand, activity based costing developed in 1981 Complexity This costing method is comparatively easier ABC method is much more complicated than the traditional method Evaluation Process The used up resources and the cost objects are required to evaluate the cost In this method, cost is dependent upon the activities that have been used by the cost objects Accuracy According to the recent trends, it can be stated that most of the organizations worldwide do not rely upon this method This method of accounting has been recognized by the organizations as the accurate method of cost allocation Application Traditional methods can be used in any kind of organization, irrespective of the number of departments and overheads Usually, ABC method is suitable and applicable for the organizations where large number of miscellaneous products are available along with high overheads Allocation Process Expenses, depreciations, salaries and other indirect costs arbitrarily accumulate in the traditional approach In this method, product parts, labours and other indirect expenses are identifiable Implementations This method might get obsolete soon Since 1981, ABC method has been implemented in several target oriented companies The most important purpose of maintaining the cost account is to idealize the effects of cost on the products. Moreover, proper and effective cost management is also essential for the decision making procedure by the management of the organization. For this purpose, activity based costing has been preferred as it makes the management concepts target-oriented and clear. Furthermore, it has been observed that ABC approach is useful for assessing the performance. It can also set standards that can enable the manager to utilize the information for the purpose of comparison. In this competitive corporate world, it is necessary to gain the competitive advantage over the competitors. Efficient allocation of cost of the products and services is one of the important aspects of achieving the competitive advantage. The traditional costing method determines the cost of production after completion of the production which is not an effective way of computing the cost. Unlike the traditional costing method, ABC system determines the cost of the products and services based upon the pocket range and customer feedback (Difference Between, “Difference between ABC and Traditional Costing”). In contrast to the traditional costing method, activity based costing method have not faced constraints by the requirement of the doctrine of the financial reporting. Rather, the activity based costing has the inbuilt flexibility to bestow special reports. These kinds of reports can facilitate the decisions of the management regarding the costs of the activities considered to production, design, delivery and sale of the products and services of an organization. This flexibility is the ultimate fact for the accounting based costing methods concentrated on accumulating cost through the key activities. Unlike the ABC method, traditional method focuses on gathering cost via organizational units. Apart from these, it has been found that ABC method can bestow superior cost allocation information when ‘costs are caused by the non-volume based cost drivers’. Eventually on the basis of the financial reporting requirement, it can be stated that traditional costing method can be adopted and used by the organizations to meet the conventional financial reporting requirement whereas the ABC method can be continued to supplement of the traditional method, instead of replacing it (GALE CENGAGE Learning, “Traditional Cost-Accounting Systems Versus ABC”). Evidences A long discussion has been conducted regarding the compare and contrast of the two commonly used methods of accounting, activity based costing and traditional costing. The discussion can be concreted with few real life evidences. In this part of the report, practical applications of the ABC methods and its effect can be discussed with the help of certain previously conducted research works and case studies upon the similar topic. Ms. Marivic Manalo had conducted a study on activity based costing. Her research was focused on the implementation of the ABC system in the several companies of Philippines. The study was restricted to the findings only on the implementation process, the derived benefits and the issues that are encountered while using the system. The study revealed that the concept of the activity based costing was not famous among the companies of Philippines as the other advanced countries like US. Through the interview process, the researcher was able to discover that 59% of the companies adopted ABC as a parallel costing system with another key costing system. The other 41% companies use activity based costing as the chief costing system of their organization. The researches demonstrated the implementation process of the organizations in that particular country. According to her findings, the companies were implementing the system on a gradual basis. The management initially piloted the process in a particular department and measured the benefits derived from the implantation of the technique on the basis of the cost incurred for the adoption of the technique. The outcome of the research reveals that ABC method is helpful for estimating the accurate product and service cost. The research also discloses that the implementation of the process enables the management to determine the products and services that have major contribution in the profitability of the organization. The method also bestows information regarding the process that needs to be improved. In contrast to these benefits, the researcher was able to find out certain problems related to the implementation process of the technique. The companies of the Philippines are not able to implement the ABC method completely as there were objections from the suppliers, clients and also from the customers. Employees’ resistance is another issue for which many of the organizations implemented the process partially (Manalo, “Activity Based Costing (ABC) Techniques - Implementation, Benefits and Problems”). Conclusion From the overall discussion, it has been found that activity based costing is able to relate the product cost to the production knowledge. Several crucial queries can be resolved through the ABC technique. Few technical questions, e.g., the production process, the required time and the amount of money that can be absorbed by a particular task can be made out with the help of the ABC method. In the study, several noteworthy facts regarding the method have been discussed. It implies that through adopting ABC method, a company can improve its overall operation though it is not free from limitations. The restriction lies in the initial phase or at the implementation phase where resistance from the employees and other stakeholders can arise and that can compel the organizations to continue with the traditional methods of costing. But it is imperative in an ever changing competitive world that the companies should discover innovative and effective techniques and need to be flexible enough to implement the changes. A preferred costing system is needed to be transparent and efficient enough to gain the competitive advantage for the organization. On the basis of the discussion, it can be stated that activity based costing is comparatively transparent than the traditional costing. Hence, it can be recommended that the companies, those are still using traditional methods, might shift to ABC method. If the companies face resistance from the customers’ perspective, then the management should take due initiatives to gradually implement the process. References Akyol, D. E. & Et. Al, “Activity Based Costing”. January 05, 2011. A Comparative Analysis Of Activity-Based Costing And Traditional Costing, 2005. < http://pdfcast.org/pdf/a-comparative-analysis-of-activity-based-costing-and-traditional-costing> Difference Between, “Difference between ABC and Traditional Costing”. January 05, 2011. Finance, 2011. < http://www.differencebetween.net/business/finance-business-2/difference-between-abc-and-traditional-costing/> GALE CENGAGE Learning, “Traditional Cost-Accounting Systems versus ABC”. January 05, 2011. Activity Based Costing, No Date. < http://www.gale.cengage.com/pdf/samples/sp665568.pdf> Manalo, “Activity Based Costing (ABC) Techniques - Implementation, Benefits and Problems”. January 05, 2011. Asia Research News, 2005. < http://www.researchsea.com/html/article.php/aid/86/cid/4/research/activity_based_costing__abc__techniques_-_implementation__benefits_and_problems.html%E2%80%83> Read More