A report on Activity Based Costing Approach

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a) Activity-based costing (ABC) is a costing approach that assigns activity costs to cost objects on the basis on cost driver usage. Costs are assigned to each major activity rather than departments and measure the resources consumed by cost objects more accurately.

b) Absorption costing absorbed all overheads into the cost of production. WWonka plc's budged and selling distribution cost and total list price is £990,000 and £9,000,000 respectively. Therefore, the absorption rate is 11% (£990,000/£9,000,000).

Designing an activity-based costing system involves four steps: (1) identifying the major activities and resource costs, (2) assigning costs to each activity, (3) determine the cost driver for each activity, and (4) assigning the cost of activities to cost objects.

c) To: Management of WWonka PLC

Report on activity-based costing approach

In the 1980s, more and more firms adopted activity-based costing to replace the volume-based costing system. The volume-based system only takes account of direct costs and uses an overhead rate that may over-cost or under-cost the product. By implementing ABC, it shows the effect of differences in activities and changes in costs. It only charges for resources consumed and generates the most accurate costs.

Firms are benefited greatly by the adoption of activity-based costing approach. ABC assigns cost more appropriately and informatively so that company could achieve better measurements on product and customer profitability. This provides information to the company for making better strategic decisions such as pricing and gives the company a cost advantage over competitors. Besides, ABC measures the activity-driving costs more accurately. This helps the mangers identify the value-added and non-value-added activities which enables the company to foster value enhancement projects and process value by making better decisions. Also, ABC draws manager's attention on those inefficiencies so that improvements can be made and allocate resources to the most beneficial product. In addition, the improvement on cost reduction causes better cost estimation for planning and budgeting. ABC can used to monitor costs as well. By comparing the costs and making adjustment, this helps the firm to control the cost trends. Moreover, ABC can be used as a benchmark to compare the performance with similar firms and make improvement. Furthermore, ABC costing helps to identify and control the cost of underutilization of capacity. Generally, many plants have excess capacity in off seasons. The ABC system helps to manage capacity level of firms to reduce the cost of unused capacity and set the price appropriately.

Although ABC brings many benefits to the firms, there are some limitations that need to aware. Firstly, WWonka plc is currently using absorption costing, installing a new ABC system is costly and time-consuming. The cost may outweigh the benefits bring to the company. Secondly, companies do not have large number of products have little benefit from ABC. As WWonka has only two types of orders, ABC approach is not that worthwhile. Thirdly, some business sustaining costs such as property tax and factory insurance require allocations to departments and based on volume measures. These costs are difficult to assign and need to use the volume-based cost driver. Fourthly, some costs such as advertising expenses, research and development are omitted in ABC system because the Generally Accepted Accounting Principles regard these costs as period costs.

ABC system provides detailed information to managers for decision-making. By activity analysis, cost can be reduced in four ways: activity elimination, activity selection, activity sharing and activity reduction.

Firstly, the managers need to identify the high-value-added and low-valued-added activities and only keep those that add value. In WWonka, packing is a low-valued-added activity as it will not decrease customers' satisfaction much if eliminated. On the other hand, delivery is a high-valued-added activity as it increases significantly the value of the product to customers.

The above pie charts show the percentage cost of activities in order A and B. From the data in part b, the selling and distribution overheads are ₤101.88 for order A and ₤182.48 for B. The list price of order B is ₤400 lower than order A, managers could adjust the list price of order B slightly in order to make order B more profitable. Besides, from the charts, we can see that the packing costs occupy quite a large portion of the total overheads in both order A and B. As packing is a relatively low-value-added activity, WWonka could lower the packing cost for example by using cheaper or recycled wrapping material and become more environmentally friendly. Furthermore, WWonka could purchase larger delivery vehicles which can carry more packages in one time. This could reduce the time of travelling back to the firm and shortens the delivery time. Moreover, in order B, the specific delivery distance is 48 miles which is nearly 5 times of order A (10 miles), it might be inefficient if deliver both A and B together by using the same vehicle. WWonka could deliver order A & B separately in order to utilize the delivery vehicles more efficiently. In addition, the other overheads contribute a high portion of the overheads as well. These cost may derives from inspections, approvals and rework. These activities can be eliminated by quality assurance methods such as ISO 9000 and total quality management. These can maintain the quality of chocolates and some of the costs can be eliminated or reduced. Finally, WWonka can improve performance and cut costs by business process reengineering, the reengineering teams can use the data in part b and reengineer the process and make improvements in every aspects.

Through activity-based management, managers can improves efficiency and effectiveness of the organization and increase profitability and competitiveness.

d) Activity-based costing brings many benefits to the company. However, it is not the optimal costing system for every organization. Generally, ABC is effective for organizations that have intensive competition, diverse range of products, overheads are the main cost of the product and high availability of information collection procedures and resources.

For single product firms, all costs are attributed to the single product directly, the overheads consumed by each product are relatively similar or equal and will only creates little distortion of costs when using volume-based-costing system. It is not worthwhile to operate ABC. However, when there is a high diversity of products, ABC calculates the costs more accurately than volume-based costing. In a product mix company, every individual product has different portions in consumption of overheads because of different product size, complexity, setup time and process. Each individual product's use of resources differs from the use of volume-based cost drivers so that it cannot measure by the volume-based-costing systems. Otherwise, it may have cost distortion and cause significant mistakes in decision. Hence, ABC is effective for product mix rather than single product firm. Besides, cost structure is a criterion to decide the effectiveness of a costing system. ABC will be most effective when overheads have a significant portion of total cost and large part of the costs is not related to production volume directly. For example, in an accounting firm, providing professional services to clients is the main job of the company. Salaries are the largest cost while indirect costs only constitute a low proportion of the total costs. In this case, labour costs are the majority of the total cost and ABC is less preferred as the costs could be traced easily. In contrast, a manufacturing firm will have totally different cost structure. The indirect overheads have a high proportion of the total costs. For these types of firms, ABC is more effective because the volume-based costing system causes inaccuracies in assigning costs and has negative impact on the company. Moreover, the availability of information collection procedures and resources is one of the factors as well. In order to operate a sophisticated ABC system, it needs plenty of funds and time. Therefore, companies need to have sufficient resources such as capital and professional technicians to operate ABC. Furthermore, companies need to do research to build up a set of remarkable procedures for the system. If a company does not have proper procedures to collect information that the system needs, it would not work properly and management cannot make the best decision and improvement for the firm appropriately. Therefore, insufficient of information cannot facilitate an excellent activity-based costing system. The more information the company collects, the easier to set up the system and run more effectively. However, on the other hand, ABC system will not work successfully if the company does not have sufficient information in setting up the procedures. Hence, availability of information is important to affect the effectiveness of ABC. To sum up, high availability of information collection procedures and resources would facilitate an effective ABC and vice versa.

In conclusion, activity-based costing system reduces distortion of costs and yields information for management to guide decision-making. Therefore, although implementing and ABC system is time consuming and expensive, it is still worthwhile to operate as the benefits from ABC usually exceeds the cost of installing the system.