Thesis on "Activity-Based Costing Cost Accounting Systems"

Thesis 6 pages (1782 words) Sources: 7 Style: APA

[EXCERPT] . . . .

Activity-Based Costing

Cost accounting systems are the basis for decisions that are made throughout a corporation to report or control the various costs of doing business and therefore have important extensive effects on the business. There are a number of different managerial cost accounting approaches including Activity-Based Costing.

Description

Activity-Based Costing (ABC) is a method of allocating costs to products and services. It is generally used as a tool for planning and control. It was developed as an approach to address problems associated with traditional cost management systems that tend to have the inability to accurately determine actual production and service costs, or provide useful information for operating decisions. With these deficiencies managers can be exposed to making decisions based on inaccurate data. The higher exposure is for companies with multiple products or services (Activity-based costing, n.d.).

ABC represents an alternative paradigm to a traditional cost accounting system and has received extensive attention during the past decade. Rather than distorting the cost information by using traditional overhead allocation methods, it traces the cost via activities performed on the cost objects (production or service activities) giving more accurate and traceable cost information (Tuncel, Eren, Bayhan, & Koker, 2005)

It doesn't change or eliminate any costs; it provides detailed information about how costs are consumed (Activity-based costing (ABC), n.d.).

History of Activity-Based Costing

The ABC method arose in the 1980s from the increasing lack of relevance of traditional cost accounting methods. The traditional cost accounting methods were designed around the 1870's -- 1920's and in those days industry was labor intensive; there was no automation; the product variety was small, and the overhead costs in companies were generally very low compared to today. However, from the 1960's to particularly the 1980's - this changed rapidly (Emblemsvag, 2008).

It was first introduced by Robert Kaplan and Robin Cooper, in 1987, as a chapter in their book Accounting and Management: A Field Study Perspective. Their focus was on manufacturing environments where increasing technology and productivity improvements have decreased the percentage of costs represented by direct labor and materials. What had historically been relatively low percentages of overhead costs (e.g., depreciation from robotics and other automated manufacturing systems) had grown in significance but was not easy to measure since the same systems were used by multiple products (Weiner, 1995).

Advantages to Activity-Based Costing

This method assesses costs of individual activities, based on their use of resources. It enables accurate costing of all activities to be obtained throughout an organization. it's easy to identify where high (and low) costs are being incurred and the cause. It can be a valuable tool for both business and process improvement. It helps with future product planning; e.g. The cost of all activities associated with a product or service can be accurately determined before it is launched. This can then help with determining pricing, and any associated expenditure (Activity-based costing (ABC), n.d.).

Disadvantages

One of the basic issues surrounding ABC is the difficulty of implementation. Identifying activities or processes to be allocated properly is cumbersome and takes a lot of effort. It requires that processes are adequately mapped throughout the organization. For a company that has undertaken a quality effort, or an effort to re-engineer business processes, a major part of the work may already be completed.

Just as anything else, ABC is no panacea, nor should it be embraced as a religion, or a fad. It is an operational strategy that needs to be carefully reviewed for applicability. The best way to approach the situation is to first rationalize a facility and its processes, identify the opportunities, and then conceptualize a solution. If this fits, use it (Activity-based costing, n.d.).

It may be difficult and costly to set up and establish, particularly if an organization is using more traditional accounting methodologies. It can be more time consuming to collect all the data and to maintain an activity-based system.

Alternative to Activity-Based Costing

Explicit Cost Dynamics (ECD) is a no allocation-based cost management system that offers an alternative to traditional cost accounting methods as well as activity-based costing.

It provides decision-makers with the relevant tools and information with which to understand the impact of costs, time, and past, current, and future activities on the bottom line of a corporation. ECD eliminates the ambiguity created by allocating costs -- thereby eliminating overbidding, unreliable predictions, and inflexibility. The ECD approach creates a costing system that cannot be manipulated to make performance numbers appear better, is well-suited to "what-if analysis," and is far simpler than allocation-based models (Yu-Lee, 2001).

ECD focuses on ensuring that managers understand the impact of their decisions and actions on the bottom line and on their cash flow. To do so requires techniques that are in complete alignment with the bottom line and with how organizations generate cash. ECD ensures this alignment by not allocating costs to products and services and by mathematically modeling how revenues and costs are incurred (Yu-Lee, 2001).

Traditional Costing vs. Activity-Based Costing

What really is the difference between ABC and traditional cost accounting methods? Despite the enormous difference in performance, there are three major differences. First, in traditional cost accounting it is assumed that cost objects consume resources whereas in ABC it is assumed that cost objects consume activities. Second, traditional cost accounting mostly utilizes volume related allocation bases while ABC uses drivers at various levels. Third, traditional cost accounting is structure-oriented whereas ABC is process-oriented (Emblemsvag, 2008).

Applicability in the Work Environment

ABC methodology is used when a project can be divided into defined activities. These activities are at the lowest function level of a project at which costs are tracked and performance is evaluated. Depending on the project organization, the activity may coincide with an element of the work breakdown structure (WBS) or may combine one or more elements of the WBS.

However, the activities must be defined so there is no overlap between them. After the activity is defined, the unit of work is established. All costs for the activity are estimated using the unit of work. The estimates for the units of work can be done by performing detailed estimates, using cost estimating relationships, obtaining outside quotes for equipment, etc. All costs including overhead, profit, and markups should be included in the activity cost (Activity-based costing, 1997).

Implementation

This method is used by focusing on the actual cost of activities, thereby producing an estimate of the cost of individual products or services. For example, an ABC cost-accounting system requires three preliminary steps: converting to an accrual method of accounting; defining cost centers and cost allocation; and determining process and procedure costs (Business definition for: ABC, n.d.).

Examples of Activity-Based Costing

ABC doesn't eliminate or change costs; it provides data about how costs are actually consumed. Using ABC means that all the individual activities that are part of a process can be accurately cost out.

Traditional Method

ABC Method

Salaries $100 Clean Door $40

Equipment $80

Paint Door $75

Supplies

$20

Inspect Door $75

Overhead $45

Send door to assembly $55

TOTAL $245

TOTAL $245

In this example, if you wanted to reduce costs using traditional data you would have to decrease salaries, or decrease costs of supplies. You don't know enough to change the equipment or overhead costs. Using ABC data you can see that it costs the same to paint and inspect the door. Using ABC these steps might be able to be combined to lower cost (Activity-based costing (ABC): What is it and how can reengineering teams use it?, n.d.).

Another example might be in financial services organizations where it will be possible to accurately determine the cost of each activity involved in processing a loan application from inputting information onto an application form to final approval of the application. In this way it will be easy to identify the most and least expensive parts of the process.

Process improvement activity could then focus on the most expensive parts of the process. A model could then be constructed showing a comparison between the existing process costs and the redesigned process and its associated costs.

Likewise, when assessing the costs of products and services, ABC can illustrate the costs of them and help in establishing the profitability of the individual products and services. This can be particularly useful in modern economies where companies are increasingly trying to differentiate and personalize both products and services and tailor them to individual needs and requirements (Activity-based costing (ABC), n.d.).

Why use Activity-Based Costing

ABC has grown in importance in recent decades because overhead costs have increased significantly and the overhead costs no longer correlate with the productive direct labor hours. The variety of products and the diversity in customer's demands have grown and some products are produced in large batches, while others are produced in smaller ones (Averkamp, 2009).

ABC makes a lot of sense for companies with multiple products or services who are suffering from inaccurate costing information and need to know which products are really winners and which are losers.… READ MORE

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