Activity Based CostingThis print version free essay Activity Based Costing.
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The purpose of this report is to explore Activity Based Costing (ABC) specifically as it applies to the application of overhead costs to jobs in a manufacturing environment. Activity Based Costing is a cost management method which applies overhead costs to jobs in a more accurate manner than that of Traditional Cost Accounting (TCA) by identifying, "Ð’â€¦the cost pools, or activity centers, in an organization and assigning costs to products and services (cost drivers) based on the number of events or transactions involved in the process of providing a product or service." (Value Based Management, 2005)
An explanation of the method of assigning costs through Traditional Cost Accounting will be provided, followed by a brief history of Activity Based Costing; an explanation of the ABC process; a comparison of allocation of overhead costs between Traditional Cost Accounting and Activity Based Costing; an analysis of the benefits and drawbacks of Activity Based Costing; and tips concerning how to go about designing and Activity Based Costing system in an organization.
Traditional Cost Accounting (TCA)
Under Traditional Cost Accounting there is a simple method by which some companies continue to implement allocation of overhead for the purpose of arbitrarily assigning indirect costs (overhead) to cost objects (products or services). When using Traditional Cost Accounting, the sum of a company's overhead is allocated among products based on some sort of volume measure. The most commonly used volume measures are labor hours and machine hours. The assumption in TCA is that there is a direct relationship between overhead and the volume of output based on the volume measure (Value Based Management, 2005).
Since an exact number for overhead cannot be determined until the end of the period (whether that period is a month, quarter, or year) a predetermined factory overhead rate must be used to apply overhead to products. This is done by estimating the overhead for the period, and then dividing it by the estimate of the volume measure for that particular period (Delphis Financial Management and Consulting, 2005). For example, if a company expects overhead expenditures of $500,000 in one year with 125,000 direct labor hours, the predetermined factory overhead rate which will be applied to any particular job would be $4 per direct labor hour. Once the period is completed, actual overhead and direct labor hours are computed for the year, and the difference between actual overhead and overhead applied to any particular job is called over (under) applied overhead.
A simple example of assignment of overhead costs under the Traditional Cost Accounting method is as follows:
Widgetland manufactures widgets with overhead costs applied at a predetermined rate of $2 per direct labor hour. Widgetland produced 10,000 widgets in April 2005 with a total of 10,000 direct labor hours. Overhead assigned to the product of widgets totals $20,000.
Under Traditional Cost Accounting, an organization may go a step further by breaking down the application of overhead by department. In this situation, cost drivers specific to any particular department are used to determine the application of overhead (i.e. direct labor for the assembly department, machine hours for the machining department, etc.). Although this method increases the accuracy of applying overhead costs, the underlying assumption (and possible incorrectness) of the direct relationship between overhead and the volume of output based on the volume measure still does not take into account the possibility of any other contributing factors to overhead costs.
The drawback of assigning costs based on a predetermined overhead rate (as stated above) is the assumption that the selected cost driver (in this case, direct labor) is what drives a large percentage of the costs in an organization. In most organizations, there is no one single cost driver, rather a multitude of cost drivers. This is where Activity Based Costing becomes more appropriate than traditional costing methods (Delphis Financial Management and Consulting, 2005)
History of Activity Based Costing
Up until the early 1980s, the traditional costing method detailed above was implemented in a majority of corporations. Most companies utilized a cost model that was developed in the early 1900s,
"Ð’â€¦when labor was the most important factor in production and product and service variety was very limited. At the time they were created, the models were reasonable representations of the internal economics at most businesses. As businesses became more complex and product and service customization grew, however, companies failed to change their models to match the changes in reality." (Hicks, 2005).
Soon, however, the drawbacks of traditional costing methods became clear to upper level management as researchers began to point out the outdated procedures and the inadequacies of those cost models. A professor at Harvard University, Robert Kaplan, began to develop an alternate costing system which was eventually given the name Activity Based Costing, and gave rise to Activity Based Management (Hicks, 2005).
Activity Based Costing (ABC)
Dependent upon which resource is utilized for research of this topic, there is a range of three to eight steps through which one may implement Activity Based Costing in an organization. Each of these independent resources carry the same requirements for implementation, however, they are organized differently dependent upon the author. For the purpose of this report, a five step process will be illustrated based on a University of Pittsburg presentation given by Narcyz Roztocki. Data from this presentation was also utilized in order to provide an illustration of Activity Based Costing through a figurative manufacturing organization named Company XYZ, which produces two products: Product A and Product B.
The five steps towards implementation of Activity Based Costing are as follows:
1. Identify activities
2. Determine cost for each activity
3. Determine cost drivers
4. Collect activity data
5. Calculate product cost (Roztocki, 1998)
This first step entails an evaluation of corporate resources. This is where a company determines the resources, funds, and processes required to manufacture any particular product. To do this, a company identifies activities which are occurrences or transactions that trigger a cost in an organization (Chutchian-Ferranti 1999).
In Company XYZ the following activities have been identified as those that bring about a cost to the organization: Set-Up, Machining, Receiving, Packing and Engineering.
Determine Activity Costs
The second step is to determine the costs of each activity. This can be done through a thorough evaluation of the processes and resources required to perform this activity; information that is often available on a departmental basis (Stenzel & Stenzel, 2005). Below are the costs per year that Company XYZ has assigned to the five activities that generate costs in an organization:
Determine Cost Drivers
The third step is to determine the cost drivers associated with each activity. A cost driver is, "Ð’â€¦a unit of output that [is] used to calculate the cost of each activity." (Chutchian-Ferranti, 1999) This is equated to the volume measure used in Traditional Cost Accounting. Where in TCA direct labor hours or machine hours are commonly used; cost drivers in Activity Based Costing are specific to the activity. Below are the cost drivers that Company XYZ has assigned to the five activities that generate cost in an organization.
Collect Activity Data
The fourth step in Activity Based Costing is to collect the activity data from a company throughout the period for which costs are being allocated for each product. For example, if a company that is looking to implement Activity Based Costing has determined that receiving is an activity in the organization and has set the cost driver to be number of receipts, this company would calculate the total cost of receiving in a given period, calculate the cost of each product by establishing how many receipts were taken for each product, and then divide the cost among the number of receipts for each product. The exhibit below illustrates the activity data that Company XYZ has collected for Product A and Product B in the five activities that generate cost:
Calculate Product Cost
The fifth and final step is to calculate the per-unit cost of the overhead. While the above-mentioned steps indicate how to allocate costs to a particular product, it is still necessary to divide those costs on a per unit basis. This is done by dividing the total cost of producing a product throughout a given period by the number of units produced in that time frame.
Let us say that Company XYZ has produced one hundred units of Product A and one thousand units of Product B. This would make the cost per unit of Product A equal to $245, and the cost per unit of producing Product B would equal $75.50.
Company XYZ Ð’â€“ ABC versus TCA
For comparison purposes, let us say that Company XYZ is currently using Traditional Cost Accounting to assign overhead costs for Product A and Product B. Product A uses 1 direct labor hour and has direct costs of $20 per unit. Product B uses 2 direct labor hours and has direct costs of $40 per unit. Overhead is applied at a predetermined overhead rate of $25 per direct labor hour. Based on this information, Product A would be assigned an overhead cost of $70 per unit while Product B would be assigned an overhead cost of $140 per unit. In comparison, as mentioned above, Activity Based Costing assigns an overhead cost of $245 to Product A and $75.50 to product B:
When looking at the two methods of assigning costs, it is clear that there is a discrepancy. The first of these is the fact that, under Traditional Cost Accounting, it costs less per unit to produce Product A than Product B. Under ABC, Product B is actually less than Product A. The reasoning behind this is fairly clear: direct labor is not what truly drives costs in Company XYZ. By breaking the costs down to the five activities indicated in Exhibit 2, XYZ is better able to assign costs to products.
The knowledge that this information provides could prove to be staggering. What if an executive at XYZ had decided to discontinue Product B because it was costing too much to produce per unit? The implications of this type of decision are phenomenal in an organization. That is the reason behind the fact that it is imperative to have an accurate costing structure in an organization.
Benefits and Drawbacks of Activity Based Costing
There are multiple benefits to the successful implementation of Activity Based Costing in an organization. The first of these is that Activity Based Costing accurately predicts costs, profits, and resource requirements associated with changes in production volumes, organizational structure, and resource costs. Where in Traditional Cost Accounting, although future costs are somewhat predicted based on the current allocation of costs, the accuracy of those predictions is dependent upon the strength of the correlation between the selected cost driver as it relates to the actual usage of overhead.
The process of collecting data while establishing an Activity Based Costing program as it relates to the activities in an organization also enables a company can track the costs of activities and work processes over time. This facilitates easier identification of the root causes of poor financial performance in an organization.
Activity Based Costing also equips managers with cost intelligence which can assist those managers in making their decisions while also drive improvements. In decision making, Activity Based Costing can facilitate the establishment of a better marketing mix since the true costs of producing a product relative to the selling price can be identified and used for the purpose of deciding which product(s) should be continued and which should be halted (12 Manage, 2005).
The most notable drawback at this point in time of Activity Based Costing is that implementation of an ABC system is very costly and very time consuming. Although it would be excellent if a consultant could come into a corporation, spend a week in training, and walk away with a new costing system, that's not exactly how it works. A large amount of training, learning, researching, and examination must be completed prior to implementation of an ABC system.
Furthermore, Activity Based Costing is not appropriate for every company. Those companies that are highly labor intensive and incur lower overhead would not benefit as much from this type of system since direct labor would be a highly accurate predictor of the minimal overhead costs (Ainsworth, 1994).
Designing an ABC system
Due to the fact that organizations vary greatly from one another, there is no one way to implement and Activity Based Costing system in any particular company. There are, however, some general guidelines that can be followed when establishing and ABC system. Paul Sharman of CMA offers the following suggestions to be taken into consideration prior to implementing an Activity Based Costing system:
Ð’Â· Ensure that evaluation for the purpose of ABC is conducted by a cross-functional team, of which a majority should come from operating functions.
Ð’Â· Have management and/or cost accountants act as advisors to the Activity Based Costing team and participate in the establishment of the ABC systems that will be used.
Ð’Â· Do not permit a consultant to provide a pre-configured "model" on which to base the costing practices of your organization.
Ð’Â· Ensure correct identification of cost objects
Ð’Â· Assign activities to costs objects that actually receive the output of said activity. Do not allocate an activity cost based solely on the argument that "it has to be allocated to something."
Ð’Â· Understand what the activity is and how to define it when analyzing activities. Do not allocate an activity based on the mentality of "how will this be allocated to the product."
Ð’Â· Only develop an ABC architecture and assign activities to cost objects after all activity is discovered for each type of resource. (Sharman, 1998)
Allocation of overhead costs to a product or job is an important part of the accounting process in an organization. It also plays into multiple decisions outside of the accounting department, including work flow design, allocation of resources, and product and marketing mixes. It is important to take into consideration the benefits offered by Activity Based Costing as well as the potential drawbacks. Although Activity Based Costing is not meant for every organization, the overall benefit of the system should be considered.
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Ainsworth, Penne (July 1994). When Activity Based Costing Works. The Practical Accountant. Boston. Vol.27, Iss.7; pg. 28, 8 pgs.
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Roztocki, Narcyz (May 1998). Introduction to Activity Based Costing (ABC): Internet ABC Online Presentation. University of Pittsburg. Retrieved June 18, 2005 from the World Wide Web:
Sharman, Paul (May 1998). ABC Systems Architecture. CMA. Hamilton. Vol.72, Iss. 4; Pg. 15, 4 pgs.
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