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The cost is considered as the firm's unit for a product or an activity that it performs. This figure may serve as a measure of value, for example, in financial reporting and it acts as a handy guide to many decisions and it can be compared with a product's sale price; if cost of a unit is less than price, the product may be worth making (Baxter, 2005). Businesses have gone really far in redesigning the costing methods in the accounting process and in fact plenty of businesses have shifted from the traditional costing method to the Activity Based Costing method. In this paper, I'll be talking about the benefit of understanding the nature and the structure of the manufacturing businesses product costs and how they can have awareness on the full cost of producing their products. In most manufacturing companies, cost accounting is inadequate and the choice between traditional absorption costing methods and the recently developed activity based costing (ABC) is one of the issues that this paper covers. The ABC method has a different concept regarding the business process for manufacturing companies and it provides them with a different way to measure the cost. The traditional absorption costing method assumes that the total cost of manufacturing is the sum of all costs of individual operations but the cost that matters to be competitive and profitable in any market is the cost of the total process.
The Activity based costing method makes competitiveness manageable through assuming that the manufacturing process is an integrated process starting from the step where materials, supplies or even parts arrive to the factory and continues even the finished product is with the end-user. According to the ABC method, service is still a cost of the product and it needs to be taken into consideration even though the customer is paying. Also, the Activity based costing method takes into consideration the down time of the machines, the cost of time needed to wait for a part to fix the machines, the cost of the finished goods (inventory) that is waiting to be shipped to dealers or end-users, and the cost of remanufacturing bad products. ABC method gives the business a better cost control and result control. Some of the questions asked if the ABC method is implemented are: should the process be done? If it is the situation, where is it best done?
The traditional accounting costing method takes into consideration what is the cost of doing a task. Also, it does take into consideration the downtime of machines which sometimes is equivalent if not more than the cost of manufacturing. Traditional costing method usually makes the wrong assumptions regarding cost. For example, Service companies do not have the ability to start with the cost of individual operations as the manufacturing companies did with traditional cost accounting. They have to start with the hypothesis that there is only one cost, which is the cost of the total system and it is fixed over any given time period. The well-known difference between fixed and variable costs and which traditional cost method is based on will not work in the services business. Also, the basic assumption of traditional cost method that capital can be substituted for labor will not work too for the services sector. As a matter of fact investing more capital means more labor. For example, if a factory buys a new machine, it will hire more people to run it. On the other hand, all fixed costs in a certain period of time cannot be replaced by other. Another example will be banks. They were trying to apply the traditional absorption costing method for decades, such as the cost of individual operations and cost of services and they weren't getting solid results due to the nature of banking business. The most important question that they should have asked from the beginning is which activity consumes the most cost and provides the most of results? The answer will be the customer service activity. The cost/customer in any bank is a fixed cost, hence, the outcome or the yield per the services provided for a certain customer volume will determine the bank's profitability. Moreover, the traditional costing method won't show the impact of the change in the products' price on the market share of the company. The activity based costing method shows that and a good example will be the Japanese auto manufacturers such as Toyota, Nissan, and Honda. The ABC showed them the damage that happened in the discount war that occurred when the Japanese automotive companies first entered the US market.
The Costing Methods
Traditional Costing Method
Traditional Costing method is a widely known for using volume based cost driver. It is the main reason behind the distortion of the products costs. The Traditional Costing method assigns overheads to products based on the relative usage of labor or labor hours to be specific and for that reason; it produces inaccurate costs of products. The problem is rooted deeply with the methodology that Traditional Costing method uses. The methodology states that producing products will always produce cost, and this does not work for activities that are not performed directly on the products. Traditional Absorption Costing method works by allocating overhead costs to the manufactured products. The methods works by assigning manufacturing indirect overheads to the manufacturing volume (ex: the number of units being produced), the direct labor hours to the produced products, and the machines working hours to the products produced. Taking an example of only machine working hours in allocating overheads to products, the main cause of the overheads imposed on the products will be machine hours. This was considered to be enough information for the manufacturing companies' financial statements. From the fundamentals of the traditional costing method, cost is assigned directly to products and not to activities on the first place. The standard report that is produced will give information on what is spent to product the product and will not show why those expenses were spent. When the manufacturing companies cut overheads spent due to the increase in their products cost, they are treating the symptoms of this increase and not the cause of this increase. This cut will result in low quality products rather than saving on cost on the long term. The cost pools for the Traditional costing method have few indirect cost pools to a single unit of the company or a factory as overall. This application of cost in the Traditional costing method is based on direct and indirect financial basis.
Activity Based Costing Method
The underlying theory behind the Activity based costing method is totally different from the Traditional costing method. The activity based costing method assumes that activities are the main cost drivers. Cost objects will create the demand for those activities thus, cost will be incurred. Activity based costing method is a different approach to cost and it improves the overall control over the overheads and the cost cause relationship. The ABC method is so flexible in providing a relation between cost and processes, cost and customers, and cost and management responsibilities. Furthermore, it focuses on activities as drivers for cost, and it uses the costs of these activities compile the total cost. The ABC method will help manufacturing companies in identifying, analyzing and improving the manufacturing processes. The ABC method accurately measures consumption of the activity, hence it measures the costs in accurate way. Through the assignment of costs to activities, managers can easily control the cost centers and even reduce them without affecting the overall quality. The most common approach in the ABC method is to start with the most common activities in the manufacturing process through analyzing them and come up with ideas that improve performance and decrease cost. The performance improvement includes cost driver analysis, the grouping of similar activities together, evaluation of the performance, and activity based costing. The cost driver should not be interpreted as an output measure since the output measure is a unit measure and it measures the how many outputs and activity produce. In ABC, overheads re assigned to a big number of cost pools and those cost pools represent most of the important activities in the manufacturing process. Also, the ABC method utilizes several indirect cost pools because there are many indirect activities linked to manufacturing process. For the method to work costs are allocated to the cost pools then suitable cost drivers are identified for each pool. The overheads are then assigned from the cost pools in a proportional way to the amount of activity used in the manufacturing process. The improvement of the cost will happen through the isolation of the activity that produce the biggest cost and work on improving it so that it will incur less cost in the manufacturing process. Hence, the total cost of production will decrease and the required target of cost reduction would have been achieved. The usage of the ABC method will eliminate the division between product and period cost, and it will improve the accounting processes. A very important part for the ABC to be effective is the correct activity classification. Activities should be classified to adding value activities and non-value adding activities. In this way, cost control will be achieved through the elimination on non-value activities and it will help in the performance improvement.
A literature reflection on the costing methods
To excel as a world-class manufacturer a company must be totally committed to quality - that is, each component, subassembly and finished good should be produced in conformity to specifications (Kaplan, 1984). Such a commitment to quality entails major changes in the way companies design products, work with suppliers, train employees, and operate and maintain equipment, but this commitment must also extend to a company's measurement systems (Kaplan, 1984). Data on the percentage of defects, on frequency of breakdowns, on percentage of finished goods completed without any rework required, and on the incidence and frequency of defects discovered by customers should be a vital part of any company's quality enhancement program (Kaplan, 1984). A nonfinancial indicator of manufacturing performance is inventory and American managers are well versed in optimizing inventory levels according to the economic order quantity (EOQ) model, which balances the cost of additional setup time with the cost of carrying inventory (Kaplan, 1984). They are less familiar with the effort, common among Japanese producers, to eliminate setup times and to implement just-in-time inventory control systems, which together reduce drastically overall levels of work-in-process inventory (Kaplan, 1984). Direct measures of productivity are important set of nonfinancial indicators since in companies publicly committed to productivity improvements, accurate measurement of productivity is often impossible because accounting systems are designed to capture dollar-based transactions only (Kaplan, 1984). Without precise data on units produced, labor hours used, materials processed, energy consumed and capital employed, administrators must deviate dollar amounts by aggregate price indices to obtain approximate physical measures of productivity (Kaplan, 1984). Improving manufacturing performance requires more of accounting systems than the timely provision of relevant financial and nonfinancial data (Kaplan, 1984). Fundamental changes in management control systems are also needed (Kaplan, 1984). In particular, there is a need to rethink the way companies use summary financial measures like ROI to coordinate, motivate and evaluate their decentralized operating units (Kaplan, 1984).
How to apply a costing method on a new product
The first step in applying a new product cost method is to collect accurate data on direct labor and materials costs. Next, we need to examine the demands made by particular products on indirect resources (Cooper, R. and Kaplan, R, 1988). Three major rules should guide this process:
The focus on expensive resources.
The emphasis on resources whose consumption varies significantly by product and product type through looking for diversity.
The focus on resources whose demand patterns are uncorrelated with traditional allocation measures like direct labor, processing time, and materials.
The focus on expensive resources will lead us to resource categories where the new costing process has the potential to make big differences in product costs (Cooper, R. and Kaplan, R, 1988). A company that makes industrial goods with a high ratio of factory costs to total costs will want a system that emphasizes tracing manufacturing overhead to products (Cooper, R. and Kaplan, R, 1988). A consumer goods producer will want to analyze its marketing, distribution, and service costs by product lines, channels, customers, and regions (Cooper, R. and Kaplan, R, 1988). High technology companies must study the demands made on engineering, product improvement, and process development resources by their different products and product lines (Cooper, R. and Kaplan, R, 1988).
the emphasize on resources whose consumption varies significantly by product and product type through looking for diversity and the focus on resources whose demand patterns are uncorrelated with traditional allocation measures like direct labor, processing time, and materials will help us identify resources with the greatest potential for distortion under traditional systems (Cooper, R. and Kaplan, R, 1988). Those resources point to activities for which the usual surrogates labor hours, material quantities, or machine hours-do not represent adequate measures of resource consumption (Cooper, R. and Kaplan, R, 1988). The central question is, which parts of the organization tend to grow as the company increases the diversity of its product line, its processing technologies, its customer base, its marketing channels, its supplier base? (Cooper, R. and Kaplan, R, 1988).
The process of tracing costs, first from resources to activities and then from activities to specific products, cannot be done with surgical precision. The process of designing and implementing an activity-based cost system for support departments usually begins with interviews of the department heads (Cooper, R. and Kaplan, R, 1988). The interviews yield insights into departmental operations and into the factors that trigger departmental activities (Cooper, R. and Kaplan, R, 1988).
To know the cost of operation is not enough for manufacturing companies and in order to succeed in a competitive market, the manufacturing companies must know the whole cost of their business chain and they should work on all part of this chain to minimize the cost and maximize the profit. Therefore, manufacturing companies are shifting from the traditional absorption costing method to the activity based costing method. An example is that is Coca Cola; they were franchisors 30 years ago with independent bottlers manufacturing Coca-Cola products and they moved into owning most of their bottling operation in the US. What mattered for Coca-Cola the most was the cost of their entire process and they didn't care about who owns the small parts of this big process. The companies' management of their costing method might be improved to reflect their current operating environment. This Company operates in an extremely competitive, highly regulated environment will shift toward the ABC method as a response to the competitive environment and they'll become more team-based. Using the traditional absorption costing methods will show that increased profitability bad been largely caused by an unexpected jump in demand. This jump will permit the manufacturing companies' facilities to operate near capacity. Despite the fact that companies expand, the companies' market share will fall and their costs will not be reduced by maintaining equipment. Also, costs will not be reduced by operating the companies' machines beyond rated capacity or even by not investing in new equipment or product development. While the ABC method is not perfect because of its financial pragmatism, the initial analysis of the activities can waste time on valuing non-value adding activities. The bureaucracy of valuating the secondary and supporting activities will also waste time. On the other hand, the ABC method is commonly and widely used for reducing costs in a fast way, improve processes in a dramatic way and provide value adding flows for the manufacturing process such as fast reengineering, benchmarking, and performance management within a certain budget. The traditional costing method focuses on costing and it is always an easy way to start up with if the business is in its young stages. The traditional costing method will also help managers identify inefficiencies in the manufacturing process and help them improve the overall process within a certain boundary.