Activity Based Costing Is A Cost Accounting Concept Accounting Essay

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According to the Burch (1994), he stated that measuring the cost and the performance of cost object and activity is a method of the activity-based costing. He claim that cost object for instance jobs, project, customer, service, product that management are trying to cost is the idea behind the activity-based costing. Resource driver and activity driver respectively measure the consumption of resource and consumption of activity. In addition, he also claim that activity-based costing try to define what is driving costs and charge a cost object for only overhead it actually consume.

According to the Jamaliah Abdul Majid and Maliah Sulaiman (2008), they stated that activity-based costing is a multipurpose tool. For instance,it can use in customer profitability analyses (Bellis-Jones, 1989), cost reduction (Brimson, 1991), cost modeling (Cooper, 1994), product-range decisions (Johnson and Kaplan, 1987) and budgeting (Kaplan, 1994). Activity-based costing system appoints costs to cost objects such as products and services and calculates the costs of personal activities on the fundamental of the activities engage to produce each product or services.

On another view, activity-based costing is a cost accounting concept based on the premise that products require an organization to perform activities and that those activities require an organization to incur costs. The systems are designed so that any costs that cannot be attributed directly to a product and flow into the activities that make them necessary. The cost of each activity then flows to the products that enable the activity necessary based on their respective consumption of that activity (Hicks,1992).

According to the Activity-based costing (ABC) is an approach for allocating overhead costs. Besides that, activity-based costing is a powerful tool for industrial marketing decision makers because activity-based costing has appear over the past 20 years

An earlier article (Stevenson et al., 1993) introduces ABC and discusses general uses of ABC in industrial marketing decision making with particular emphasis on the impact of ABC on profitability measures.(John C. Lere,2000) Activity-based costing (ABC) is a system measure the cost of activities and provided useful, timely and accurate information to the related management.

Section 2: Background Research

According to Robert Kaplan and Robin Cooper, activity based costing (ABC) as a was first introduced in 1987 that published in the book titled "Accounting and Management: A Field Study Perspective."They focused on manufacturing environments where increasing technology and productivity improvements have decreased the percentage of costs represented by direct labor and materials. In 1990, the ABC was fist expanded.Besides that,they stated that financial institutions also have different product sets which have created chances for cross-product subsidies. In the end,they concluded that it could be used to more precisely in allocating costs.

Besides that , some changes had undergone in banking industry in terms of its sensitivity to staffing levels and related productivity during the past five years. The industry would be searching for ways to more accurately allocate such costs to products and customers because personnel expenses is the biggest part of non-interest expense in financial institutions . Activity based costing can be a useful tool to making decisions for allocating the costs.

For the manufacturing sector, according to the Dr.P.Chellasamy, he stated that the concepts of ABC were developed of the United States during the 1970s and 1980s.According to Jesper Thyssen, he stated that the origin of ABC dates back to 1983-1984 (Kaplan 1983; 1984a,b; 1985a,b; 1986) although the term "Activity-Based Costing" was not coined yet. The origin grew out of dissatisfaction with dominating costing procedures at the time, variable costing and traditional full costing, which were argued to be obsolete in modern manufacturing environment. In 1987-1992, Robin Cooper and Robert S. Kaplan also ventured into a series of "innovative actions research cycles" (Kaplan 1998) when the ABC was developed.

Section 3: Literature Review

Activity Based Costing

Limitation of ABC

Advantages of ABC

According to the chart, Activity Based Costing has the advantages and limitation when we are implementing in an organization. Hence, we will further explain about it as follows.

Advantages of of ABC

According to Carles(2001), he stated that several authors have described the main advantages of using ABC costing [Innes and Mitchell, 1990; Bellis-Jones and Develin, 1995; Malmi, 1997].,which as follows:

The product and service costing is more accurate, especially the non-volume -related overhead in the organization.

It is possible to analyze costs by areas of managerial responsibility and

customers by using the ABC.It helps to recognize the way in which customers directly influence the cost structure of the business. Hence, it helps to analyze customer profitability.

It is a cost behavior that makes people more understand.It is also identifying the costs of complexity, variety, and change inherent in both kind of service offered and customer-specific requirements.

Focuses on the value-added activities, which are those activities that create value to customers. On the other hand, the company should identify the non-value-added activities and try to eliminate them although the non-value-added activities that enables value adding activities to occur at the same time .

It is beneficial to performing capacity analysis which measures the costs of resources

used rather than the costs of resources supplied because that has the big difference being excess capacity. We will use the practical capacity, which means the capacity reflecting the maximum level at the efficient organization to undergo this analysis,

It reduces the risk of the company and provides a more useful decisions in the future. Therefore, it is not only depending on the analysis but also depending on its ability to using a correct diagnosis in the company's situation to make an organization successful.

Limitations of ABC

According to Peter F.Druker (1999), some companies that activity-based costing will cause spending too much time, effort and even money on gathering and going over the data that is collected. The manager annoyed in an organization because there have too many details that invovle in ABC. On the other hand, insufficient data will occur when we are lacking of details. The data provides in an organization will affect the results when using ABC . This will happens in businesses that were no intention of using ABC costing as main approach.

Besides that, an article aimed at certified public accountants who hard to support the new approach (activity-based costing) was written by Cokins(1999). Hence,in his articles, he explained that activity-based costing usually will show the best with small amount of detail and estimated more cost figures. However, he stated that when accountants try to apply ABC, they will try to achieve the obtain more accurate inormation that is both difficult to accomplish and need time to acomplish it. However, it will be likely to be a failure when people are going to apply it.

Furthermore, another article entitled "Overcoming the Obstacles to Implementing Activity-Based Costing" was also written by Cokins(2000). Hence, he noted that the managers ignore the cardinal rule so the activity based costing usually leads to a failure. Moreover,the advantage of average cost rates, many overly detailed information and the failure to connect information to action that proved that it also interferes with ABC projects. By knowing these concepts, Cokins(2000) agreed that CPAs can improve their roles as business partners and consultants.

In addition,another limitation is that activity-based costing software can be costly. Mark Henricks(1999)stated that most ABC practitioners find that special-purpose ABC software is required to make the task manageable and easy to undergoes in an organization.

Moreover, time can also be a factor for businesses seeking a quick fix which means that ABC costing can be successful in a short run .Continuingly, Henricks(1999) noted that although some companies see results almost instantly, it typically long time to experience the benefits of ABC.

According to Peter(1999), he stated that some overhead costs, such as chief executive salary, are difficult to be assigned to products and customers. 'Business sustaining' which are termed by the costs and are not assigned to products and customers because it is not meaningful to an organisation. Although someone may argue that costs cannot trace to activities should be "arbitrarily allocated" to products and it is important to realize that the main purpose of ABC is to provide accurate information to management. Hence, it cannot deny that any cost of the organization by using ABC approach, should be assigned in an arbitrary manner.

Steps in implementing activity based costing

According to Mr. Ian(2003), an ABC system involves the following stages as follows:

The major activities should be identified which happen in an organization.

Determine the cost driver for each main activity (for example, number of set-ups, machine hours, number of inspections etc.)

Create a cost pool for each major activity

The costs of activities to products (goods or services) according to the products to consumption of these activities (Using the extent to which the cost drivers are used as a measure of this demand)to be traced

Example:

Thus, the examples will further explain how the steps are undergone.

Assume Henry's Company produces two products, which are product 'A' and 'B'. Both of them are produced on the same equipment and undergoing same processes. The products will change with the volumes in which they are sold and therefore the volumes in which they are produced.

Product 'A' is a high volume product whereas product 'B' is a low volume item. The table shows the all details as follows:

Products

Machine hours per unit

Direct labor per unit

Annual output units

Total Machine Hours

Total Direct Labor Hours

No. of purchase orders

No. of "set-ups"

Product A

4

8

12,000

40,000

40,000

120

60

Product B

4

8

1,200

20,000

30,000

100

50

Total

60,000

70,000

220

110

The cost of these activities as follows:

RM

Volume related

120,000

Purchase related

100,000

Set up related

200,000

Total

420,000

An 'Activity Based Costing system would handle it this way:

Activities

Volume related

Purchase related

Set-up related

Cost Traced to activities

RM120,000

RM100,000

RM200,000

Consumption of activities

60,000 machine hrs

220 purchase orders

110 set-ups

Cost per unit of consumption

RM6 per machine hrs

RM500 per order

RM2,000per set-up

Cost trace to product

A

RM72,000

(12,000XRM6)

RM60,000

(120XRM500)

RM120,000

(60XRM2000)

B

RM7,200

(1,200XRM6)

RM50,000

(100XRM500)

RM100,000

(50XRM2,000)

Hence,cost per unit under ABC:

For product A=RM21{(RM72,000+RM60,000+RM120,000)/12,000units}

For product B=RM131{(RM7,200+RM50,000+RM100,000)/1,200units}

A Traditional volume based costing system would handle it this way:

Cost centre allocated costs RM420,000

Overhead rate per machine hour RM7 (RM420,000/60,000 hrs)

Overhead rate per direct labour hour RM6(RM420,000/70,000hrs)

Cost per unit of 'A' = RM28 (4 machines hours at RM7)

Cost per unit of 'B'= RM24 (RM6X 4,at RM6per hour)

Thus total cost allocated to product 'A' = RM336,000 (12,000 X RM28)

And total cost allocated to product 'B'= RM28,800(1,200 X RM24)

From the calculations,it shows the big difference by using the traditional volume based costing and ABC.

Section 4: Analyses and Discussion

Other than ABC costing system, there have another system called traditional costing system. It allocates overhead directly that is based on the basic of predetermined such as machine hours or the labor costs. Activity-based costing (ABC) provides information more accurate than traditional costing system because its assign overhead costs using the following steps that we mentioned at section 3.

Traditional costing system allocates overhead to products on the basic of predetermined plant wide that is using direct cost and machine hours. The total overhead cost such as depreciation on expensive plant, property and equipment, maintenance has increased in the rapid development environment. On the other hand, the amount of direct labor used in industries has been reduced. In this situation, it is not suitable to use the basic predetermined overhead rates based on direct labor because direct labor and overhead have no correlation.

It will happen the product costs being wrongly because the companies are using overhead rates based on direct labor. Companies prevent the distortion by using the machine hours as the basic to allocate overhead in an automated manufacturing. Manufacturing process is complex, only machine hour is not fulfilling to allocating all the overhead cost. In this situation, managers decide to us "activity based costing".

Michael H. Granof Professor, David E. Platt Assistant Professor and Igor Vaysman Assistant Professor had done some researches about the ABC. They had analyzed about the difference between ABC and traditional costing.

The table below shows the differences between traditional costing and activity-based costing.

Traditional Costing Systems

ABC Costing Systems

Cost pools

Accumulate costs into departmental cost pools.

The costs in each cost pool are heterogeneous because they are costs of many major processes and generally are not caused by a single factor.

Accumulate costs into activity cost pools, which are designed to correspond to the major activities or business processes.

By design, the costs in each cost pool are mainly caused by a single factor called 'cost driver'.

Allocation base

Allocate costs to products using volume-based allocation bases such as units, direct labor input and machine hours.

Allocate costs to products, services and other cost objects from the activity cost pools by using allocation bases corresponding to cost drivers of activity costs.

Cost object

Focuses on the cost of the single cost object (e.g. unit of product or service)

Focuses on the costs of many cost objects of interest (e.g. units,batches, product lines and business processes).

Cost

Inexpensive to use and maintain.

Expensive to use and maintain.

Decision support

Leads to overcosting and undercosting problems.

As they unable to align allocation bases with cost drivers

Provides more precise information to support the decision made by an organization.

As they able to align allocation bases with cost drivers

Cost control

Considered as departmental exercise rather than a cross functional effort.

By providing summary costs of organizational activities,they allow for prioritization of cost-management efforts.

Example of ABC and Traditional costing

Now we will have an example for making decision to pricing and production by using ABC and traditional costing.

Assume that the Craze Ball Company produces two types of bouncing balls; one has a hollow center and the other has a solid center. The same equipment is operated to produce the balls in different runs. Between batches, the equipment is cleaned, maintained and set up in the proper form for the next batch. The hollow center balls are packaged with two balls per package whereas the solid center balls are packaged one per package. During the year, Craze Ball expects to produce 1,200,000 hollow center balls and 1,400,000 solid center balls. The overhead costs incurred have been allocated to activity pools as follows:

Activity

RM

Purchasing of materials

220,000

Setup of machines

300,000

Packaging

360,000

Testing

240,000

Cleaning and maintenance

280,000

Total overhead costs

1,,380,000

By analyzing the activity pools,we have to identify the cost drivers, estimated the total expected units for each product and calculated the unit cost for each cost driver.

Activity

Cost Driver

Total Expected Units for Cost Driver (1)

Total Cost (2)(RM)

Unit Cost per Cost Driver (3) = (2)÷ (1)(RM)

Purchasing of Materials

No. of purchase orders

120

240,000

2,000

Set up of Machines

No. of setups

300

300,000

1,000

Packaging

No. of containers filled

2,600,000

360,000

0.14(rounded up)

Testing

No. of tests

4,000

240,000

60.00

Cleaning and maintenance

No. of runs

240

280,000

1,166.67(rounded up)

The activity by product is shown in the following table.

Expected Use

ABC Cost Assigned

Activity

Cost Driver

Unit Cost (3) (RM)

Hollow Center (4)

Solid Center (5)

Hollow Center (3) Ã- (4)

Solid Center (3) Ã- (5)

Purchasing

No. of purchase orders

2,000

50

50

RM100,000

$100,000

Setup

No. of setups

1,000

120

120

120,000

120,000

Packaging

No. of containers filled

0.14

400,000

2,400,000

56,000

336,000

Testing

No. of tests

60.00

1,600

2,500

96,000

150,000

Cleaning and maintenance

No. of runs

1,166.67

80

160

93,333,60

186,667.20

Totals

RM465,333.60

RM892,667.20

To calculate the per unit overhead costs under ABC system, the costs assigned to each product are divided by the number of units produced. The unit cost for a hollow center ball is RM0.39 and the unit cost for a solid center ball is RM0.64.

Overhead costs assigned to hollow center balls/Number of hollow balls

=465,333.60/1,200,000

=0.39(RM)

Overhead costs assigned to solid center balls/Number of solid balls

=892,667.20/1,400,000

=0.64(RM)

Under the traditional method, the total costs for all balls would be divided by total direct labor costs for all balls to determine per unit cost. Estimated direct labor costs for the year are RM1,500,000, which are RM500,000 and RM1,000,000 respectively. Thus, per unit direct labor costs are RM0.42 for hollow center balls (RM500,000 ÷ 1,200,000) and RM0.71 for solid center balls (RM1,000,000 ÷ 1,400,000). Per unit cost to produce balls incurred two steps:

The predetermined overhead rate is calculated by dividing total overhead costs by total direct labor dollars.

Overhead to each type of product is to be allocated by multiplying the overhead cost per direct labor cost by the per unit direct labor costs for the two balls.

Step 1 : Calculate the direct labor cost

Total overhead costs/Total direct labor costs=1380,000/1,500,000

=0.92 per direct labor cost

Step 2 : Allocation of overhead

Overhead cost per direct labor cost X per unit direct labor cost

For hollow balls: 0.42 X 0.39=0.16 overhead per unit

For solid balls : 0.71 X 0.64=0.45 overhead per unit

A comparison of the overhead per unit calculated using the ABC and traditional methods often shows a different result:

Craze Ball Company 20X0 Overhead per Unit

ABC method(RM)

Traditional method (RM)

Hollow Ball

0.39

0.16

Solid Ball

0.64

0.45

In this example, the overhead charged to the hollow ball using ABC is RM0.39 and much higher than the RM0.16 calculated under the traditional method. The RM0.39 is a more accurate cost for making decisions about pricing and production. For the solid center ball, the overhead calculated is RM0.64 per unit using ABC method and RM0.45 per unit using traditional method. The reason for the differences is the traditional method determines the cost allocation using direct labor costs only. Hence, a product with high direct labor costs will allocate more of the overhead costs than a product with low direct labor costs. The number of orders, setups, or tests the product actually uses does not affect the allocation of overhead costs when direct labor dollars are used to allocate overhead.

Section 5: Conclusion

In conclusion,ABC is an approach that helps us in an organization when we make decision. On the other hand, it also has the limitations of the ABC approach. Besides that, according to Mr. Ian(2003), the volume of the product are not related to some activities , by using cost drivers that are independent of volume.

He stated that three major categories are divided at the product level:

Unit level

Batch-related

Product sustaining

Product costs are accumulated by these categories.

Facility-sustaining expenses (Head Office, PR etc) are incurred to support the entire firm, therefore it is a common and joint activity .Hence, they should not be assigned to the product's cost.

ABC systems are models of resource consumption in an organization but not spending in the firm. The total organizational resources required to produce a good, or perform a service (for example, the product) by using the ABC systems.

It is important to emphasize that ABC systems identified priorities for managerial attention and not to provide the basis of decisions relevant to costs by themselves.

Perhaps,it is not only provides the basis on the product costs that calculates accurately, but it also manages overhead costs in general so the ABC systems have attracted many people of the Accountancy Profession. Moreover, it is probable to understand and manage costs more effectively by collecting and reporting on the significant activities in which a business engages. By the way,it is in the area of cost management, where Activity Based Costing may have its greatest potential. ABC system was first developed more than ten years and some firms go to the extent of implementing this approach to establishing more realistic costing for their products and services.

Fortunenately, we feel familiar about the topic because in the previous trimester we had learned about the topic. However, the more challenge part is we had gone through the journals by finding via website or in library online database. In the process, many journalists, specialist of accounting fields had done their research by using ABC system on their industry such as universities, manufacturing companies and hospitals .In addition, we had searched about the ABC that is implemented in the other way. Therefore, the examples we are given is slightly different from the textbook that we learned.

The part 4 example, which mentioned that ABC provides a way to allocate costs more accurately when overhead costs are not incurred at the same rate as direct labor costs. Thus, the more activities identified the more complex the costing system becomes. Computer systems are necessary for complex ABC systems.On the other hand, to keep it manageable,some companies may limit the number of activities. Yet this approach may have some allocations in being arbitrary.Thus, ABC provides a more accurate estimate of costs in making management decisions.

References - muz follow A-Z

Brown, I.R. (2003). Pricing and profit management [Electronic Version],pp 1-3.

Lere, J.C. (2000). Activity-based costing: a powerful tool for pricing. Journal of Business & Industrial Marketing, Vol.15,pp.23-33

Stevenson, T.H., Barnes, F.C. and Stevenson, S.A. (1993), ``Activity-based costing: an emerging tool for industrial marketing decision makers'', Journal of Business and Industrial Marketing, Vol. 8 No. 2, pp. 40-52.

Jamaliah Abdul Majid & Maliah Sulaiman (2008). Implementation of activity-based costing in Malaysia. Asian Review of Accounting Vol. 16 No. 1, 2008 pp. 39-55.

Kaplan, R.S. (1994), "Flexible budgeting in an activity based costing framework", Accounting Horizons, June, pp. 104-9.

Thyssen, J., Israelsen, P., & Jorgensen. B. (2004). Activity Based Costing as a method for assessing the economics of modularization - a case study and beyond [Electronic Version], 7.

GRÍFUL. C. (2001). Activity-Based Costing Methodology for Third-Party Logistics Companies. IAER: FEBRUARY 2001, Vol. 7, No. 1, pp. 133-146.

Burch, J., (1994) Cost and management accounting. Modern approach. West Publishing Company, ST Pual, MN.

Granof, M.H., Platt, D.E., & Vaysman, I. (2000). Using Activity-Based Costing to Manage More Effectively [Grant Report], 9.

Weiner, & Jerry. (1995). Activity based costing for financial institutions [Electronic Version], 1.

Latshaw, C.A., & Danile, T.M.C. (2002). Activity-based costing: usage and pitfalls [Review of Business], 2-3.

Popesko, B. (2010). Utilization of Activity-Based Costing System in Manufacturing Industries - Methodology, Benefits and Limitations [Electronic Version], 3.

Narcyz Roztocki, & Sally M. Schultz. ( ). Adoption and Implementation of Activity-Based Costing: A Web-Based Survey [Electronic Version], 1-2.

Roztocki, N., & Weistroffer, H.R. (2006). Stock Price Reaction to Investments in Information Technology: the Relevance of Cost Management Systems [Electronic Version], 27.

Kocakulah, M.C., Kelley, A.G., Ruggieri, M., & Aquilina, N.D. (2007). Utilizing Activity-Based Costing To Manage The Maintenance Function In A Manufacturing Company [Electronic Version], 57.

Cheatham, C., Dunn, P., Dean, I., & Cheatham, L., (2004). ACTIVITY-BASED COSTING FOR SMALL FIRMS [Electronic Version], 1, 3.

Monir Zaman. (2009). The Impact Of Activity Based Costing On Firm Performance: The Australian Experience [Electronic Version], 200.

Anderson, S.R., & Kaplan, R.S. (2004). Time-Driven Activity-Based Costing [Tool-Kit], 132.

Bordovsky, T., VanZante,N.R., & Wagman, G.R. (2005). Activity-Based Costing System Required For Successful Customer Relationship Management [Electronic Version], 36.

Akyol, D.E., Tuncel, G., & Bayhan, G.M. (2005). A comparative analysis of activity-based costing and traditional costing [Electronic Version], 44-45.

Krishnan, A. (2006). An Application of Activity Based Costing in Higher Learning Institution: A Local Case Study [Electronic Version], 78.

Jamaliah Abdul Majid & Maliah Sulaiman. (2008). Implementation of activity based costing in Malaysia [Electronic Version], 39.

Eden, Y. & Ronen, B. (2002). The same things in a different guise? Activity-based costing and activity-based management, 47.

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