activity based costing

activity based costing

2007

Activity Based Costing

Introduction

The fierce competition in business has driven corporations to focus not only on generating more revenue but also reducing the production costs The situation drives them to find suitable strategy that helps them to asses whether their production has met the required quality within the assigned budget or not

Concerning the intention to define the costs associated in production in manufacturing , this will discuss about how activity based costing is beneficial in manufacturing . Activity Based Costing is a costing system

that assigns costs based on activities performed . The adoption of activity base costing (ABC ) system is beneficial for the company since they can assess which department is efficient and which ones are not . Prior to the discussion of the benefits of ABC system in manufacturing , this will highlight about type of production costs and costing methods

Production Costs

Concerning the production costs , in particular , costs of production fall into two groups regarding their responsiveness to different levels of production attained the two groups are as following

Fixed costs are simply not responsive to production levels

If there are only fixed costs , the Figure 1 Fixed Cost

Source : Piana , 2003

For instance , the cost of renting an office is a fixed cost , since usually the contract fixes it for a certain period of time (say one year , without any reference to the income produced by the operations that take place in the same office

Variable costs grow with higher levels of production (proportionally or not . If there are only variable costs , at zero production the costs will be zero (Piana , 2003 Figure 2 Variable Cost

Source : Piana , 2003

Costing Method

The discussion of costing method usually concerns two well-known subjects , Absorption Marginal Costing and Functional-based and Activity Based Costing (ABC . They are well-known , because there is hint of controversial issues within them . The question of which is better between Absorption and Marginal Costing for example , is already answered by the GAAP which favors the Absorption costing . Nevertheless , business practitioners found that the Marginal /Variable costing is more suitable for performance evaluation purposes

Absorption Costing and Marginal Costing

GAAP favors the absorption costing because it conforms to the matching concept . Absorption costing is a costing method where all types of cost -whether they are fixed or variable- are assigned to units produced . The matching concept would then regulate that all costs are recognized when the product they are attach to , is sold . This is the strength of Absorption Costing (Hansen Mowen , 2003

However , business practitioners discover that when it comes to evaluation activities , the use of Absorption costing is inappropriate The use of Absorption costing will not necessarily connect net income with managerial performance

The weakness of Marginal /Variable costing is the fact that it does not conform to the matching concept . Costs are not matched accordingly to the presence of revenues . Theoretically , the use of marginal costing method will allow costs of a certain product to be recognized before the product deliver their revenue . This would mean that the cost is recognized ahead of its time . It is this view that makes the GAAP regulates Marginal Costing not to be applied in assembling published financial statements

On the other hand , as a performance evaluation tool , Marginal Costing is more objective than Absorption costing . In Marginal Costing , only variable cost is assigned to the product . Fixed cost is recognized as a constant periodic cost . Thus , marginal costing would not allow changes in inventory to effect net income . The system would fairly evaluate the performance of sales managers . It would not allow managers to be penalized for something over which they do not have power (Hansen Mowen , 2003

Activity Based Costing

Activity Based Costing is a costing system that assigns costs based on activities performed . The activities could be unit level , batch level product level or factory level . All costs related directly to the making of the product is accumulated and then divided by the amount of unit produced or working hours used in to obtain unit level costs

Costs related to scheduling , preparation , allocation and set ups are accumulated and divided with number of batch in to obtain the batch level costs . Costs that related to designs , development , prototype making , advertising and warehousing are accumulated and divided with number of product in to obtain the Product level costs . And all costs related to air conditioning , light and security of the factory are accumulated and divided by the to obtain factory level costs (Hammer

Because all of the cost drivers have been correctly determined , the application of Activity Based Costing will eliminate the cost distortion phenomena . In comparison with Functional-based costing method , the Activity Based Costing provides more accurate cost allocation activities

However , there are managers who complain about the cost and resources required to develop a sound method of Activity Based Costing . They also complain about the periodic cost of having to perform the complicated calculations every month . Despite the obvious benefits , several managers still refuse to apply the Activity Based Costing method within their company , because of cost and simplicity reasons (Hansen Mowen , 2003 .Activity Based Costing (ABC ) in Manufacturing

Activity-based costing is a concept explaining that a company 's outputs (products and services ) give rise to the need for operating , management and administrative activities that , in turn , make it necessary that costs has incurred in providing those activities (Kaplan , 2005

At one side , these operating , management , and administrative costs can assign to the outputs that caused them to be incurred by routing them first to the activities that made them necessary and then to the outputs that made the activities necessary . At the other side , the volume and mix of outputs can used to project the demand for the various operating management , and administrative activities and then this demand can used to project the costs of providing those activities

Importance of Activity Based Costing

A major advantage of using Activity Based Costing (ABC ) is it avoids or minimizes distortions in product costing as results of arbitrary allocations of indirect costs . Unlike traditional costing which cannot be tied to specific outputs , ABC generates useful information on how money is spent , if a department is cost-effective , and how to HYPERLINK "http /www .dod .mil /comptroller /icenter /learn /bestprac .htm " \o "benchmark " benchmark (compare oneself against others ) for quality improvement

Concerning the statement , we witness that traditional direct labor-based cost accounting system has obvious drawbacks since it cannot explain what company should do with set-up , material handling , and administrative costs on low-volume once the company experience their product sold less than producing costs (Daly 2002 . Below is the figure describing the relation between traditional costs and real costs

Figure 1 Traditional Cost Vs . Real Costs

Source : Daly , John L (2002 . Activity-Based Pricing for Competitive Advantage . Retrieved December 5 , 2007 from http /accounting .smartpros .com /x33328 .xml

Benefits of Activity Based Costing in Manufacturing

There are several benefits when implementing activity based costing in manufacturing companies as following

Determine the most profitable divisions /departments , products , and customers

Find out the unprofitable divisions /departments , products , and customersHighlight the contributor in a company financial performance

Forecast the associated production costs accurately

Easily determine the factors that cause poor financial performance

Accomplish better products positioning

(12 Manage , 2007

Example of ABC in Manufacturing : Steinway Piano

Looking at the corporate pro of Steinway Piano , we find Steinway Pianos can be considered as a good candidate to employ ABC method . This is because this organization , Steinway Piano , needs to manage all costs in to define costs appropriately while providing accurate cost-based pricing for their products

There are many reasons for Steinway Pianos in using ABC method . One of them is this organization only produce a few goods in its one year , but with the quality , which can be spelled out very satisfied Therefore , to maintain this excellence , the company needs the correct calculation in costs (Kevin Kennedy Associates , Inc , 2005

For instances , in to make a handmade legendary collection of pianos using the rarest and finest wood , Steinway Pianos have to reckon extra costs and time to get the materials . This matter because besides the raw material (the wood ) are rarely available , only 1 out of 10 available wood that can meet the Steinway Pianos ' standard . In addition Steinway Pianos use skillful workers that have great skill in making excellent pianos

Using of traditional cost allocation method also represents a good way in arranging or managing an organization . However , in some companies the use of traditional accounting system is not suitable since it is incompatible

Steinway Pianos is one of example . The additional extra costs in making pianos as explained at previous section will bewilder the management when categorize or allocating into definitive quantification . This matter will complicate in make decision about final goods price

Despite this matter , there are some dysfunctional decisions if a company likes Steinway Pianos using traditional cost allocation

Decision about to the number of product output in one year

Decision about price sells of set

Decision to control extra costs Conclusion

Activity based costing is only a concept that facilitate an organization in managing its expenditure . Since there are many accounting method that a company may use , therefore , there is no problem if the organization does not use it . This is because to some extent traditional cost allocation represents a good way in managing a company although it also has drawbacks

Interestingly , when a company employs Activity Based Costing , they just see unit cost formula : Unit cost is the average producing one unit of output . It calculated by dividing the of production by the Reference

12 Manage (2007 . Analyzing product and customer profitability Explanation of Activity Based Costing . Retrieved December 5 , 2007 from http /www .12manage .com /methods_abc .html

Hansen Mowen (2003 . Management Accounting . Southwestern . Oklahoma

Hammer , Lawrence H . Carter , John . Usry , Milton F (2001 . Cost Accounting . 13ed .Southwestern . New York

Kam , Vernon (1990 . Accounting Theory . John Wiley Sons . NewYork

Kaplan , Robert S (2005 . Activity-Based Costing : Modified Approach Harvard Business School , 2005

Kevin Kennedy Associates , Inc (2005 . Activity-Based Costing For The Small And Mid-Sized Manufacturer . Retrieved December 5 , 2007 from HYPERLINK "http /www .rapid-response-consulting .com /clients .html http /www .rapid-response-consulting .com /clients .html

Max , Mitchell (2005 . OX ABC VALUE ! Retrieved December 5 , 2007 from HYPERLINK "http /www .performaxgrp .com " http /www .performaxgrp .com

Piana , Valentino (2003 . Costs . Retrieved December 5 , 2007 from HYPERLINK "http /www .economicswebinstitute .org /glossary /costs .htm http /www .economicswebinstitute .org /glossary /costs .htm

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