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Free Essays | Accounting Essay - ABC Traditional Costing

I. Introduction

Multiple objectives are pursued in this paper. The first objective is to discuss and compare traditional cost accounting methods and activity-based costing methods. The second objective is to determine the extent to which activity-based costing methods are used in the United Arab Emirates (UAE). The third objective is to determine why some organizations in the UAE continue to use traditional cost accounting methods. The fourth objective is to develop a recommended strategy to increase the use of activity-based costing in the UAE.

II. Traditional Methods of Costing

The traditional costing model includes six elements. These elements are as follows (Garrison, Noreen, & Brewer, 2007):

  • For product-costing purposes, a company is separated into functional areas of activity - manufacturing, marketing, financing, and administration
  • Manufacturing costs of direct materials, direct labor, and manufacturing overhead are subject to inventory costs
  • Direct materiel and direct labor costs are considered to be traceable directly to specific products
  • Manufacturing overhead costs are treated as indirect product costs, and they are charged to specific products at predetermined overhead rates
  • When a single, company-wide, predetermined overhead rate is used, overhead is charged to all products with no consideration for differences in resource use
  • The functional costs of marketing, financing, and administration are accumulated in cost pools, and they are applied in the period in which they are incurred; these costs are not treated as product costs nor are they related to specific products in product profitability comparisons

Full costing (absorption costing or activity-based costing) considers all costs to be product costs. Thus, all overhead costs are allocated to costs of production for specific products. Traditional costing, by contrast, includes only the costs for those factors that change with the production of an additional unit of good or service.

In the variable costing approach, all overhead costs are not allocated to costs of production for specific products. Although activity-based costing (ABC) has gained widespread acceptance, some disagreement continues to exist with respect to the merits of each of these approaches to costing for purposes of control and decision-making within organizations (Garrison, Noreen, & Brewer, 2007).

In an ABC system, overhead costs are attached to units of product at the time of production. Overhead, therefore, becomes a part of costs of good sold when units of production are sold. Under an ABC system, all costs are classified according to their functional categories, or activities (Garrison, Noreen, & Brewer, 2007).

In a traditional costing (marginal costing) system, however, overhead is recognized as an expense in the reporting period in which such expense is incurred. These overhead expenses do not become a part of cost of goods sold at any time. Under a variable costing system, costs are classified according to cost behavior, i.e., fixed costs or variable costs.

Fixed costs are those costs that will be incurred by the organization regardless of production levels while variable costs are those costs that are only incurred as additional product units [goods or services] are created (Garrison, Noreen, & Brewer, 2007).

ABC systems can lead to sub-optimal managerial decisions in some instances when the true timing of cost expenditures is not reflected in the decision-making process. The application of traditional costing (marginal costing) methods to conduct a breakeven analysis, however, can overcomes the timing problem. Thus, this issue is one advantage of the traditional costing approach (Garrison, Noreen, & Brewer, 2007).

III. Activity-Based Costing

An advantage associated the ABC system, however, is that the true costs of specific products are more accurately reflected because production overhead is allocated across all product categories. A major goal of an ABC system is the development of a costing system that also can function as a management tool by providing timely and accurate measurements of resource use (what, how, where, when, and cost). The ABC system is intended to provide more accurate measures of the resources used by each product.

Further, an ABC system also may be used to develop product component and part level data to enhance the detail and value of cost information. This capability of the ABC system satisfies the concerns associated with the price-setting mechanisms within an organization by providing more reliable product cost information (Sale, 2007).

Another objective of the ABC system is to make the costing system more useful and relevant for design and production departments within companies. These departments tend to be more interested in identifying the cost of alternatives and opportunities for cost reduction and permanent savings (Sale, 2007).

ABC systems are supportive of the process of management. Some companies use their activity-based cost information in their product pricing decisions. This practice increases the probability that revenues will exceed the costs of resources used in production. Activity-based costing models also can be used by managers to reduce resource use while holding revenues constant. When resource use is lowered, unused capacity is created. The unused capacity can then be eliminated or used in other production.

Resource use can be lowered by educing the number of times activities are performed, or resource use can be lowered by increasing the efficiency with which activities are performed. Through a combination of reducing the quantity of activities performed and increasing the efficiency of performing the remaining activities, companies can maintain production levels and revenues while reducing resource demand (Sale, 2007).

The ABC model has two dimensions. The first dimension is cost. The costdimension includes cost information about resources, activities, and cost objects. This dimension supports economic evaluations of the strategy and operations of a company. The second dimension is process. The processdimension includes performance information about the work of the company. This information supports judgments about why work is performed and how well it is performed. The process dimension brings organizational operations directly into the cost system (Sale, 2007).

Activity-based costing, thus, is defined as a methodology that measures the cost and performance of activities, resources, and cost objects. Resources are assigned to activities, then activities are assigned to cost objects based on their use.

Activity-based costing recognizes the causal relationship between (a) cost drivers and (b) activities. This definition includes a wide range of cost and performance information. An ABC model based on this definition has two main perspectives that are companion concepts to the two dimensions discussed above. The first perspective is cost assignment. This perspective reflects the need that companies have to (a) assign costs to activities and cost objects, and (b) to analyze critical decisions. These decisions involve issues such as the following (Sale, 2007):

  • Pricing
  • Product mix
  • Product design
  • Setting priorities for improvement

The cost assignment perspective identifies the significant activities of a company, and it attaches costs to each activity. This perspective also assigns costs to the cost objects that rely on the activities. Knowing the cost of activities makes it easier to understand the how, why, and when of resource use within a company (Garrison, Noreen, & Brewer, 2007).

The second perspective of the ABC model is the processperspective. The process perspective reflects the need that companies have for a new category of information, which is information about the drivers of work within a company, as well as information on the effectiveness and the efficiency of the work. Managers use such information to devise strategies and methods (a) to improve performance and (b) to increase the value of products to customers (Garrison, Noreen, & Brewer, 2007).

IV. Comparison of ABC Methods and Traditional Methods

The ABC system recognizes that costs originate from and that they increase or decrease in response to factors other than production volume and direct labor input, which are the primary considerations in traditional cost accounting. According to the proponents of the ABC system, the other factors or activities considered in the ABC approach are better indicators of product costs than are the outcomes of traditional cost accounting procedures. ABC systems assign costs to products based on their consumption of activities, such as order preparation, storage time, wait time, engineering changes, and internal product movement.

As a result, the ABC system provides companies with (a) better product costs and (b) a better understanding of the effects of product pricing and product mix decisions on profitability (Sale, 2007).

ABC systems estimate the cost of the resources used in company processes to produce outputs — goods or services. While attempts are made to interpret activity-based costs within the context of the traditional fixed versus variable cost framework, this approach is inconsistent with an activity-based cost system’s measurements of resource use costs. The fixed versus variable cost classification attempts to classify the likely change in spending or supply of a resource. Measurement of unused capacity through the application of the ABC model provides the necessary link between the cost of resources used and the cost of resources supplied (Garrison, Noreen, & Brewer, 2007).

The ABC resource use cost information can be used by managers to monitor and predict the (a) changes in demand for activities as a function of (b) changes in output volume and mix, process changes, introduction of new technology, and changes in product/process design.

Further, based on planned change, managers can predict resource shortages or excesses of capacity.Such predictions will allow managers to modify decisions so that activity demand will balance with activity supply (Garrison, Noreen, & Brewer, 2007).

ABC systems use separate activity cost drivers for each activity. Activity cost drivers are not devices to allocate costs. Rather, such cost drivers represent the demand that output requirements place on each activity.

Because traditional cost systems use allocation bases that do not represent the demands for support resources by activities, the volume variance for a period can be zero even though in actual practice under or over capacity may develop in the production processes (Garrison, Noreen, & Brewer, 2007).

Activity-based cost analysis is used in conjunction with process improvements. By measuring the costs of business processes such as (a) purchasing, (b) sales, (c) materials management, and (d) other activities, companies develop a greater understanding of the true costs of production (Garrison, Noreen, & Brewer, 2007).

The arguments favoring the ABC system are supported by the recognized deficiencies of the traditional costing approach based on fixed costs and variable costs.

The advantage of the ABC system over traditional costing is comprised of (a) the combination of higher levels of accuracy in cost allocation and, (b) the higher correlation between costs and revenues (Garrison, Noreen, & Brewer, 2007).

V. Awareness of ABC methods in the UAE

There is a strong awareness the ABC system among accounting firms and among companies in the United Arab Emirates. This statement is supported by a search of the Internet that reveals that,

  • A large number of accounting firms that are located in the UAE offer ABC system-related services
  • A large number of production companies that are located in the UAE are advertising internal accounting vacancies that require (among other qualifications) ABC system skills
  • Universities that are located in the UAE offer courses of study that focus on ABC system skills

Some companies that are located in the UAE, however, continue to rely on traditional costing methods.

While activity-based costing is the most appropriate basis for allocating costs to products and segments and results in a more accurate measurement of resources consumed by a particular product, service, or business segment, there nevertheless must be questions and issues that cause some companies to stick with traditional costing methods. The UAE has adopted many of the standards promulgated by the International Accounting Standards Board (IASB), which recognizes the ABC system. Thus, prevailing standards do not provide an answer to the question.

One argument put forward is that the ABC system does not effectively incorporate the concept of attributable-cost. An attributable-cost refers to any cost that could be eliminated if a particular activity were discontinued. Attributable costs would include all costs, whether fixed or variable, associated directly with the particular activity and the activity’s share of allocated costs that could be eliminated if the affected activity were to be discontinued.

The costs incurred by a company, however, do not change with activity-based costing. The ABC system changes the allocation of costs, not the character or class of costs. The status of costs as attributable or non-attributable is changed by ABS system allocation (Garrison, Noreen, & Brewer, 2007).

Ahmed and Karim (1995) reported that the Financial Accounting Organization for Islamic Banks and Financial Institutions (FAOIBFI) issued Financial Accounting Statement No. 2: Concepts of Financial Accounting for Islamic Banks and Financial Institutions in 1993 that requires Islamic banks to use traditional cost accounting methods. The FAOIBFI statements do not apply directly to other types of companies, but it is possible that some Islamic banks insist that the companies with which they participate also observe this requirement. It is equally probable that many companies continue to rely on traditional costing methods because no one has persuaded them that it would be beneficial for them to change to the ABC system.

VI. Conclusion

Proponents of activity-based costing have challenged the idea that full absorption costs are inappropriate for managerial decision making.

ABC proponents contend that all costs are variable in the long-run and thus subject to management action.A further argument is that the problem has not been the concept of full cost but, rather, the methods used to allocate costs to a particular cost object. Better measurements of resources consumed are achieved, according to this argument, through correctly identifying the factors that cause a particular cost to change and use these cost drivers as our allocation base.

According to the arguments of ABC proponents, the ABC approach, thus, should be applicable to any segment analysis (Garrison, Noreen, & Brewer, 2007).

The Telecommunications Regulatory Authority (2005) in the UAE has issued cost accounting guidelines that require (a) adherence to the principle of cost causality and (b) the direct attribution of costs where possible. Thus, it is recommended that industry associations in the UAE take the lead in promoting the application of the ABC system by emulating the action of the Telecommunication Regulatory Authority.