Activity Based Costing: Benefits And Implementation

Comparison of activity based costing with traditional costing method

The report is presented below sets out the research based findings on the activity based costing.  The findings have been accumulated on the basis of research done on two widely discussed journal articles based on activity based costing. The report has been divided into separate sections. These sections represent the explanation of the selected management accounting topic, which in the current report is selected to be “ACTIVITY BASED COSTING”. The next section is grounded on the basis of the explanation of the studies selected from these journals and the purpose laid behind. A stark comparison is made between the two studies that highlight the similarities and differences attached to the two studies. The basic purpose of these studies is to incorporate into the management accountants of Australia the learning outcomes derived from the two studies based on the activity based costing

Activity based costing method is set to make the organisations work more effectively. This method works on the gathering of overall information about the different activities that the entity is spending on. It is analyzed that companies facing issues in the process system needs to implement the proper activity based costing method so that proper bifurcation of the cost could be made in different process of organization. The costing method is useful for the distribution or division of the overhead costs occurring in the organisation. The difference that lies in this method as compared to the traditional costing method is the cost allocation technique. The technique used in this costing method is more logical than arbitrary division (Dale, and Plunkett, 2017). The management accountant’s job in this costing method is to make a list of all the activities that the entity has entered into. The costs that the management accountants have computed for the organisation are going to be divided in the ratio of actual consumption of the activities by all the departments in which the entity is working (Cooper, 2017).  However, in order to adopt the activity based costing in the process; organization should undertake proper costing based policies and measures (Greasley, 2017).

ABC Costing is a method of allocating the indirect, overhead costs to products or services and departments which are involved in the production process and the allocated costs are based on consumption activity. It is an accounting method and managerial activity .It is considered as a supplemental costing method. It is a component of many products like ERP and TRM.  Activity Based Costing is a proper way of assigning the indirect costs in the production process .ABC Costing is exact and fine approach than the traditional costing method. The total of both costs direct and indirect are required for production. It is used as a tool to understand the customer costs, product, profits which is based on the production process .ABC Costing also help in some strategies like pricing, outsourcing, downsizing (Hoozée, and Hansen, 2017).

Implementing activity based costing in an organization

The traditional costing method was based on the use of the volume basis being the machine hours and the labour working hours. The use of traditional method went obsolete with the changing market scenarios (Frazier, 2014). Now the organisations are facing a huge and significant rise in the overhead costs which cannot be distributed fairly with the use of the traditional costing method. Moreover, the overhead costs are related to the core production activities, and by using the machine or labour hours as a division basis all the departments incur the costs. As a result, even those departments that have not added to the cost in any of the activities, they also suffer the burden. Further, the main drawback that persisted in the traditional approach was that the production batches were paid no attention to (Hopkins, et al., 2017).

The activity based costing on the other hand works on logical grounds. This method brings accuracy in working. All the areas that are a waste for the organisation are identified and the focus of the management accountants goes on reducing that waste and enhancing the performance efficiency. Instead of using the machine hours or the labour hours, this method uses different criterion for dividing the costs. The basis used is called cost drivers, and can be anything depending on the activities. E.g. number of inspections, quality checks, power consumption, occupied floor space, output rejection, handling and storage quantities, setup quantities, assembling quantities, number or solder boards, quantity of insertions, etc. (Christopher, 2016).

The reasons why the activity based costing method is getting an edge ahead of the traditional costing systems are the advantages that an entity is benefitted by on using this costing method. Certain advantages are mentioned as follows:

• The basic cause and effect relationship between the activities that incur the costs and the products that consume the costs is identified. This helps in precise and fair cost distribution.
• The division on the basis of cost driver helps in bringing transparency in front of the management. The management now knows the real areas that need attention and support for cost reduction. Further, the cost driver identification helps to understand the real areas within an activity that forms the foundation of cost occurrence.
• Apart from reducing the wastage the costing method helps in fixing the sale prices using more informed and solid cost grounds. The budgets that the company prepares on the basis of forecasted costs and profit margins turn around to be more appropriate when the company uses this method.
• The chances of errors are reduced as everything is more clear and transparent to all the working divisions of the organisation. Every part of the entity’s working counterpart knows their responsibilities and the areas they need to excel in.
• The decision making quality of the management gets improved as they now get the information not only about the quantified cost but also about the analysis of the reasons that work behind that cost occurrence (Weygandt, Kimmel, and Kieso, 2015).

• Product cost are accurate – ABC helps in accuracy and reliability in product cost
• Ascertain the activities for the cost object – ABC uses different type of cost drivers .Many of them are transaction based not the product based .ABC  involved within and beyond the factory to find more overheads
• Ascertain of overhead costs –ABC helps in determining the costs to area of processes, departments besides the product cost.
• Helps in decision making – ABC helps in decision making and fixing in selling prices of product
• Cost Management –ABC is very useful to management in terms of information and cost driver rates on transaction volumes (Kaplan, et al. 2014).
• Helps in reducing the cost
• Provides benefits to service industry- In service organization there is no direct costs, some of the costs are overhead ,they don’t hold stock of service.
• Provide better understanding ,profit margins
• Allocate the overhead in proper manner to product and processes

• More expensive and complex-ABC have multiple cost drivers which are more complex than traditional product method and it is more expensive.
• Difficult to select the cost drivers, varying costs, common costs.
• Measurement difficulties –In the ABC system, there are some difficulties to measure and necessary to implement it .It require proper management for the measurement of the cost drivers (Kumar, and Reinartz, 2018).
• Time  consuming in collection and preparation of data
• Proper data is not available from accounting reports
• ABC’s reports are not always check and conformed by Generally Accepted Accounting Principles .and it can’t be used for external reporting
• Conflicts may be arise due to traditional costing methods
• No surety of using this system where the overhead costs are small or less than the total operating costs.
• The ABC Costing mainly  follow the method of cost allocation .It segregate the cost –
• Fixed costs
• Variable costs
• Overhead costs
• Direct material and wages are easy to find but difficult to allocate or assign the indirect costs .Some weighting sort are needed in the cost allocation process where resources are commonly used. Cost driver creates the value or drive the cost of the activity (Lang field-Smith, Smith, Andon, Hilton, and Thorne, 2017).
• APPLICABILITY OF ACTIVITY BASED COSTING
• It is applicable on the financing ,costing ,accounting
• It is applicable on partial views also
• Allocate more resources on products or services and departments which are profitable
• Helps in controlling  the costs at any level
• Wasted cost or unnecessary costs may be eliminated.

The failure of the activity based costing method takes place due to the various demerits that are attached to this method of costing. These demerits involve the following:

• Understanding this method and applying this method differ significantly. It is somehow easy to understand this method, but when it comes to the application of this method it is very complex task. Owing to a large number of cost drivers and cost incurring activities, confusion is created that leads to chaos and complexities (Mohammed, Hu, Obrenovic, and Aina, 2017).
• Being a complete method transformation that happens in the organisation after the application of the activity based costing model, it becomes difficult to maintain this model. The organisation is bound to face difficulties in relation to high costs every other day.
• Training costs are necessary to be incurred by the entity for making the managers and employees more acquaint with this method (Greasley, 2017).

PURPOSE:  The purpose attached to this study understands the reasons behind the successful implementation of the ABC method the industries that are working in the manufacturing sector. The scope is not limited to the benefits that are accrued to those industries, but to the manner in which the management has used the activity based costing method to provide support to the strategic and the operating decisions of the enterprise (Gylling, et. al 2015).

RESEARCH QUESTIONS: Lists of research questions have been raised by this method are as follows:

• Does the activity based costing method has resulted in generating more satisfaction for management accountants in terms of reduced costs, better measurement of performance etc. as compared to the traditional costing methods that the management followed earlier?
• Has the decision making system got improved after the implementation of this method of costing, i.e. how well the information provided by this method is used?
• Are specific examples available where the management satisfaction seems supported when decision making comes?

Benefits of activity based costing

FINDINGS: The research has been conducted with the use of face to face and telephonic interviews. The communications done with the respondent parties have helped to generate the findings. As far as the satisfaction in terms of cost efficiency, reduction, and measurement is concerned, the response given by most of the respondents suggests a positive reply. All the measures of satisfaction as laid in the research question have been answered affirmatively in majority. Management accounts have respondent that the application of the activity based costing model have helped to majorly control the costs. But there are visible improvements in the system that prevailed for measuring the cost performance (Tsai, et. al 2014).

A company manufactures two products A and B and the cost pattern is –

Fixed overhead$200000 per month and are absorbed on the basis of direct labour hours

Budgeted labour hour $20000 per month

Some following activity are carried out by the company

Budgeted production of X is 1500 units and Y is 4200 units

The company wants to make 25% profit on full production costs.

• ACTIVITY BASED COSTING

The Pental  Company will follow the two products in this process and following bifurcation of the these products on the basis of cost drivers have been given as below.

This table shows the difference in the methods and use of ABC costing to bifurcate the expenses in different process.

There is a positive standing that foots between the satisfaction that the management generates from the application of this method and the frequency with which the management makes use of the information that the method generates. The information use is increased for every aspect of management accounting operations including, strategies used for pricing, product continuation, improvement and innovation decision, etc (Plank, 2018).

The various examples that are vibrant as a satisfaction indicator are emphasised in form of the versatile uses this method has been placed into. These include decisions made for sourcing, pricing and product mixing, profitability of consumer, process improvement, operating decisions, performance measurement, product designing, and etc.

PURPOSE:  The main purpose of this research journal is to bring in highlight the benefits that make the activity based costing advent as a costing method when competitive markets come into the frame. The advantage that are paved by this method are tried to be gathered by focusing light on the effect of this coting method to enhance value in the organisation. In spite of different benefits that are showered, the study mainly aims on the benefit offered in terms of better pricing decisions (Plank, 2018).

Demerits of activity based costing

RESEARCH QUESTION: The research question laid by this research study is stated as follows:

• Has the activity based costing model provided valuable results as far as the competitive pricing decisions are discussed?

FINDINGS:  The study has contributed to formulate certain solid conclusions. The traditional and alternative costing methods other than the activity based costing method have proved to be less effective in making pricing decisions. The activity based costing method using organisations have found to strike higher profitability and competitive advantage than the alternate costing method users. When the competition and volume of the organisation increases, the better costing method stands out to be activity based costing. The reasons for the activity based costing method being better than any other method is its informative reporting. The real life company which has has  been taken would be Pental company.

Similarities

• Both the studies have incorporated the use of significant information reporting that is required for any sort of advantage that can be flourished out of the application of the activity based costing method.
• The common benefit that the studies incorporate involve the better pricing technique that is generated on using the activity based costing method of cost allocation.
• The benefits that the method accrues are studied in both the studies in those markets that are highly competitive and where the business enterprises are working edge to edge every day to attain a place better than the other (Weygandt, Kimmel, and Kieso, 2015).

Differences

• The first study is working to state about an overall satisfaction generation from the application of this costing method. However, the main focus of the second study is on the benefit in form of better pricing strategies.
• The first study has worked more on the uses that the activity based costing model has been put around nowadays. While the second study has a clear cut objective to harness the cases that are relevant in the competitive markets and relate to pricing strategies.
• There is no hypothesis made in the first research study. However two hypotheses are made in the second study. They are related to the feedback that the market generates (Schaltegger, and Burritt, 2017).

1. It is important to understand for the management accountants that the application of the activity based costing model do not result in the same benefits in every organisation. There are cases where success had been observed, but it completely depends on different factors that what will be the overall outcome of the application of the model.
2. The activity based costing model needs to be applied in all the areas related to the costing method of the entity in order to gain success. Applying the method in one area and leaving the other can create haphazard results (Eldenburg, et. al 2016).

1. The benefits that this method generates for the entity become less effective when the markets are already highly informative and provide overall feedback related to the competitors.
2. To attain profit and to generate better performance, there may seem need to identify the organisational capacity that is not used in the production function and is uselessly adding to the cost. But in the competitive markets it is important to understand that the unused capacity is useful at the times when the market demand is high (Noreen, Brewer, and Garrison, 2014).

Conclusion

The nature of the working of the organisation and the economic conditions in which the organisation operates are the major determinants that decided whether any kind of method of accounting or costing shall be successful or not. The determinants that are highly prioritised include the follow up that comes after the adoption of any method. If the entity is good in monitoring the process of method implementation and continuously improvises the way in which the method reacts in the entity, then the method shall bring out positive results only. It is analyzed that Implementation of ABC is necessary for the better management, measurement of performance, proper allocation of costs, describing the investments in new technology, improvement in the quality of the products, supporting to the managements.

References

Christopher, M., (2016). Logistics & supply chain management. 2^nd ed, UK: Pearson.

Cooper, R., 2017. Target costing and value engineering.3^rd ed, Australia, Routledge.

Dale, B.G. and Plunkett, J.J., 2017. Quality costing. 2^nd ed, Australia Routledge.

Eldenburg, L.G., Wolcott, S.K., Chen, L.H. and Cook, G., 2016. Cost management: Measuring, monitoring, and motivating performance. Wiley Global Education. 12(1) pp.99-110.

Frazier, W.E., (2014). Metal additive manufacturing: a review. Journal of Materials Engineering and Performance, 23(6), pp.1917-1928.

Greasley, A., (2017). Simulation modelling for business.3^rd ed, USA: Routledge.

Greasley, A., 2017. Simulation modelling for business. 2^nd Australia: Routledge.

Gylling, M., Heikkilä, J., Jussila, K. and Saarinen, M., 2015. Making decisions on offshore outsourcing and backshoring: A case study in the bicycle industry. International Journal of Production Economics, 162 (2), pp.92-100.

Hoozée, S. and Hansen, S.C., (2017). A comparison of activity-based costing and time-driven activity-based costing. Journal of Management Accounting Research, 30(1), pp.143-167.

Hopkins, M.A., Allsopp, D.W.E., Kappers, M.J., Oliver, R.A. and Humphreys, C.J., (2017). The ABC model of recombination reinterpreted: Impact on understanding carrier transport and efficiency droop in InGaN/GaN light emitting diodes. Journal of Applied Physics, 122(23), p.234-285.

Kaplan, R.S., Witkowski, M., Abbott, M., Guzman, A.B., Higgins, L.D., Meara, J.G., Padden, E., Shah, A.S., Waters, P., Weidemeier, M. and Wertheimer, S., (2014). Using time-driven activity-based costing to identify value improvement opportunities in healthcare. Journal of Healthcare Management, 59(6), pp.399-412.

Kumar, V. and Reinartz, W., (2018). Customer relationship management: Concept, strategy, and tools. 4^th ed Australia: Springer.

Langfield-Smith, K., Smith, D., Andon, P., Hilton, R. and Thorne, H., (2017). Management accounting: Information for creating and managing value. 2^nd ed, Australia: McGraw-Hill Education Australia.

Mohammed, A.N.N.A.M., Hu, W., Obrenovic, B. and Aina, A.A.M., (2017), January. An empirical assessment of the link between Decision support system (DSS) capabilities, competencies and firm performance: A mediating role of absorptive capacity. In Proceedings of the 2017 International Conference on Management Engineering, Software Engineering and Service Sciences 40(1), pp.13-17

Noreen, E.W., Brewer, P.C. and Garrison, R.H., 2014. Managerial accounting for managers. New York: McGraw-Hill/Irwin.

Plank, P., (2018). Mix Decisions., In Price and Product-Mix Decisions Under Different Cost Systems  3(1), pp.13-27

Plank, P., 2018. Introduction. In Price and Product-Mix Decisions Under Different Cost Systems (pp. 1-5). Springer Gabler, Wiesbaden.

Schaltegger, S. and Burritt, R., (2017). Contemporary environmental accounting: issues, concepts and practice.3^rd ed, USA : Routledge

Tsai, W.H., Yang, C.H., Chang, J.C. and Lee, H.L., 2014. An Activity-Based Costing decision model for life cycle assessment in green building projects. European Journal of Operational Research, 238(2), pp.607-619.

Weygandt, J.J., Kimmel, P.D. and Kieso, D.E., 2015. Financial & managerial accounting. 2^nd ed, Australia: John Wiley & Sons.

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