Activity-based costing (ABC)

Management Accounting

            Activity-based costing (ABC) is a method of product costing that gives more accurate unit product costs than traditional absorption costing techniques. This method came into use in the early1980s due to lack of relevance in traditional cost accounting techniques. The traditional cost accounting techniques came into being between 1870 and 1920 when the industry concentrated on labor as automation was missing. In those times, the variety of the products was little and the company’s expenses were commonly low. Nevertheless, this changed speedily in 1980s with the inception of ABC (Ostrenga, 1992).

            Traditional absorption costing is an accounting method where fixed and variable costs of producing goods are taken by dissimilar cost centers. In giving all the products and services can be priced to cover the billed costs. This method enables both fixed and variable costs are fully recovered. Nevertheless, it should be noted that should the sale of goods or services be lost following the price being elevated, the firm loses returns that would have ultimately contributed to its expenses (Friedman & Lyne, 1995).

            Compared to activity-based costing, absorption costing emphasize on total cost including variable and fixed. As a result, it is not so applicable for the firm’s management to apply it in decision making, forecast and management. Another demerit is the fact that the business administrator’s importance is on total cost, the cost volume proceeds association is not put in consideration. The business administrator requires application of his perception and feeling in decision making (Turney, 1996)

            Activity-based costing has been regarded as the best ally of production as opposed to the earlier traditional cost accounting. Experts assert that the traditional cost accounting methods are liabilities rather than being an asset to the organization. Activity-based costing (ABC) is regarded as the most significant innovation of management of the century. This is due to the differences that exist between the ABC and the traditional accounting techniques. The assumption is made in the traditional methods that cost objects devour resources while in activity-based costing cost objects consume activities. This is seen as a major management benefits as it gives accurate unit product costs. Activity-based costing utilizes drivers at various levels while traditional cost accounting frequently uses volume related allocation bases. Studies suggest that ABC is process oriented while traditional cost accounting is structure oriented (Campbell and Mills, 1997).

            Activity-based costing (ABC) provides thorough information from the processes up to assessment of costs and management ability. Conversely, traditional cost accounting methods merely assign costs or capacity down onto the cost objects. This is done with no consideration of any cause and effect relationships (Albright &Smith, 1996).

            In comparison of consumption of resources as opposed to consumption of activities, activity-based costing acknowledges that it is not possible to manage costs. ABC asserts that it is what is being done that can be managed after which the costs will alter as a result. Conversely, the fundamental supposition in the traditional methods is that costs can be managed which is very difficult. Statistics evident that most business administrators have realized the hard way it is nearly impossible to manage the costs.

            Studies reveal that activity-based costing mindset is that it gives way for a vast array of measures when it comes to improving productivity. This is achieved by investigating analytically what going on. This provides an opportunity for one to be able to identify surplus capacity and avoid misallocation of resources. An outcome of this is that costs are cut down the conventional way, but it might also cause a reallocation of capacity to places where it is needed. This enables activity-based costing to yield high productivity in a most effective manner as compared to traditional way (Bakke & Hellberg, 1991).

            Another major difference is that of volume related allocation in traditional methods as opposed to drivers at numerous levels applied in ABC. For cost assignment, traditional cost accounting techniques tend to utilize direct labor and other volume associated allocation bases. This is mainly due to its history but as expenses have increased and new innovations have come this has noticeably changed.

            However, in activity-based costing, costs are assigned depending on the cause and effect relationship. Costs in ABC are assigned after comparing the relationship between the actual process called the activities and cost objects.  This is captured using drivers which are consequently not allocation bases in the traditional sense. Studies depict that even though drivers work in similar manner mathematically, they are estimates of definite cost behavior. The drivers can as a result be utilized in identification. In addition, they are the significant cost factors as they are associated to the real processes (Miller, 1996).

            For every unit in production unit level drivers are actuated. For instance, for an operator and a machine producing one unit per unit time, the connected direct labor becomes a unit level cost driver. This is consequently a volume associated driver comparable to the traditional allotment bases. For batch level drivers, for every batch made, the drivers are triggered. For instance, in production planning, arrangement is done for every batch not considering the size of the batch. In this case, the number of batches can be an excellent driver.

            Additionally, product level drivers are actuated for every product not considering the batches produced and the count of units. The drivers arise by the individual being of a product. For instance, the amount of product growth time per product to ensure the additional product growth period a product triggers, more product development expenses should be allocated to that product. Finally, facility level driver are never connected to the products in any way. This means that costs traced by drivers of that nature will for that reason be allotted to untraced products. The disparity between allotment and tracing is that allotment is rather subjective while tracing is founded on the cause and effect relationships.

            It is evident that the conventional practice of fixed and variable costs is not very important. In activity-based costing (ABC), all the overheads are incorporated. Nonetheless, this method utilizes a unique usage and characterization of both fixed and variable costs.  A fixed activity cost exists following the very existence of the activity while an inconsistent activity cost alters as the productivity of the activity alters.  The characteristic is especially helpful in different enhancement efforts.

            Experts argue that ABC is process oriented while traditional cost accounting is structure oriented. Traditional absorption costing methods emphasizes on the organizational charts instead of the definite process. Traditional absorption costing accounting systems are as a result structural oriented. This implies that the process view is entirely absent. The outcome is that it is not possible to ask what should be done as the procedure is not known.

            The other question is how capacity is going to be managed. Research indicates that capacity is considered as an expense and is got effortlessly in the accounting structure. The primary subject is that of resource administration as resources is what is needed to carry out. Although the resources are evaluated as a cost, its measures can only be determined by looking into and analyzing the processes. Activity-based costing is process oriented and compiles information from the activities. It can therefore be applied in identification of what requires to be done and also how to assign resources effectively.

            Activity-based costing allows the managers to match the resource needed with the existing capacity effectively. As a result, ABC aids in improving productivity of the firm. Studies conclude that the structure oriented approach of traditional absorption costing systems provides no support in decision making while assigning capacity to equivalent resource requirements. Within a given time, this results in inefficient cost management and reduced profitability.

            Another gain of ABC is based on aspect of process orientation and how the method is applied and implemented. For the reason that the process can focus attention towards the causes of costs connected to cost objects and processes, the method is seen as something more than a ordinary method of cost accounting. This means that ABC invites new way of administration. This includes enabling a constant improvement of product and process design by finding out the critical factors of success. In addition, ABC connects other information with cost information enabling more improvement. ABC allows identification of quality costs and orientation of the process. This gives way to very quality methods of management with a positive impact to the organization.

            Activity based costing system assists the organization to manage overhead and comprehend profitability of products and customers. Experts agree that ABC is one of the most and powerful tool applied in decision making. ABC provides a precise costing of not only products and services but also consumers and distribution channels. It provides a clear understanding of overheads to every individual. I terms of usage of costs, ABC uses unit costs instead of total costs.

            Activity-based costing brings together constant improvement programs and exposes the non value activities. Another benefit of activity-based costing is that it supports the performance of top management and enables costing of both value streams and supply chains. The method is used by the management of the organization to identify all the areas that have gained from improvement of the process. ABC provides the benefit of benchmarking, a systematic approach that finds out the processes with the biggest probability of improvement.

            Studies reveal that practices and methods of management have evolved over the last ten years and that change is going to continue in the future. Experts assert that management is moving from the traditional vertical to horizontal management. This is basically a change from a function orientation to process orientation. Initiatives like total quality management and benchmarking are programmed to develop a companies work processes and activities scheduling. This is done to efficiently and professionally meet the changing needs of the customers (Maxwell, 2000).

            The management information systems of the business tracks and provides information about the horizontal nature of the firm. Experts observe that this has lagged considerably after the needs of its administrators. Activity-based costing and management fills this information requirement by giving the cost and operating information that reflects the horizontal view. The focal point of activity-based costing is on precise data concerning the actual cost of products and services. ABC also focuses on accurate data related to the processes, actions, delivery channels, customer segments, contracts, and ongoing projects. Activity based management allows this cost and operating information functional by giving value evaluation, cost drivers, and measures of performance to commence and support improvement efforts and make better decision (Innes & Mitchell, 1998).

            A recent survey by researchers reveals that activity-based costing has improved the performance of over eighty percent of the investigated companies. A good number of managers agree that the traditional accounting method cannot meet the managerial needs of today’s business environment. Business analyst predicts that profitability optimization and planning of the budget provided by activity based costing would be one of the top initiatives for business improvement.  Considering the economy, activity based costing is back in fashion and has improved the performance of companies in a miserable economy. The companies tend to center their resources on obtainable customers, instead of looking for new clients (Doran & Dowd, 1999).

            Research reveals that activity based costing can assist in separation of the profitable ones from the non-profitable ones. The method can be applied in looking for means of raising profits without raising prices of products drastically. ABC provides driver based budgeting as compared to traditional driven budgeting that is based mostly on perception and therefore not business driven. ABC to some extent allows customer evaluation meaning the customer base grows and ensures that the customers are loyal. Activity based costing aids by allowing the companies to comprehend better the value of their customers (Innes & Mitchell, 1995).

            In conclusion, it is evident that activity based costing is applicable and quite important for any organization that needs to improve its performance. Proponents of activity based costing insist that the method can be used to solve the problems associated with the earlier accounting methods. This is because the traditional methods frequently fail to determine accurately the production cost and connected services. The effect of this is that the mangers make erroneous decisions that consequently affect the business (Innes & Norris, 1997).

            Activity based costing gives the managers an opportunity to attribute costs to activities and products more precisely than traditional costing methods. The performance accountable for the costs can be recognized and passed on to users just after the product or service utilizes the activity. Some of the merits of activity based costing is that it offers is an better means of identifying huge overheads and looks at the means of sealing with them (Innes & Mitchell, 1991).

            Rather than allocating costs randomly, activity based costing uses the cause-effect relationship to allocate the costs objectively. After costs of the processes have been found, the cost of each process is recognized to each product. This is done to the degree that the product uses the activity. This enables activity based costing to identify areas of elevated expenses per unit and therefore focus attention to getting ways of lowering the costs. Activity-based costing is as a result a method of product costing that gives more accurate unit product costs than traditional absorption costing techniques (Kaplan & Cooper, 1998).

References

Albright, T and Smith, T 1996, Software for activity-based costing, Journal of Cost Management. (Fall): 47-58.

Bakke, N and Hellberg, R 1991, Relevance lost? A critical discussion of different cost accounting principles in connection with decision making for both short and long term production scheduling. International Journal of Production Economics (24): 1-18.

Campbell, R, Brewer and Mills, T 1997, Designing an information system using activity-based costing and the theory of constraints. Journal of Cost Management (January/February): 16-25. 

Doran, D and Dowd, J 1999, Depreciation and amortizing cost in activity-based costing systems, Journal of Cost Management (September/October): 34-38.

Friedman, A and Lyne, S 1995, Activity-based techniques: the real life consequences, CIMA.

Innes, J and Mitchell, F 1991, Activity-Based cost management: a case study of development and implementation, CIMA.

Innes, J and Mitchell, F 1995, Activity-based costing in the UK's largest companies: a survey, CIMA.

Innes J, and Norris, G 1997, The use of activity-based information: a managerial perspective, CIMA.

Innes J and Mitchell, F 1998, A practical guide to activity based costing, Kogan Page/CIMA

Kaplan, R S and Cooper, R 1998, Cost and effect: using integrated cost systems to drive profitability and performance.

Maxwell, J C 2000, Failing forward: turning mistakes into stepping stones for success, Thomas Nelson.

Miller, J A 1996, Implementing activity-based management in daily operations, John Wiley

Ostrenga, M et al 1992, Ernst & Young Guide to Total Cost Management, M J Wiley.

Turney, P 1996, Activity-based costing: the performance breakthrough, Kogan Page/CIMA.