Analysing different approaches and methods of costing

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Today manufacturing company are facing a fierce global competition in dynamic global market. It needs to increase productivity at reduced cost and achieve the higher profit to lead the market and continue the operation. Estimating the various manufacturing cost more accurately has become a strategic objective a manufacturing company in rival competition with other company.

( Malstron, 1984, p.9 ) stated that the functions of cost estimating for a manufacturing company are include:

Check quotations from suppliers,

Aid the make-or-buy decision,

Evaluate product design alternative, cost estimations are particularly useful at the early design of a product where 70% of its cost is determined (Duverlie and Castelain, 1999),

Assist long-term financial planning,

Help control manufacturing cost,

Provide standard for production efficiency.

However, managers may not realise that the accounting method that they have been using (traditional costing method) for stock valuation in financial reporting provides them with inaccurate and sometimes irrelevant information for purpose of making strategic decision with regard to pricing, cost control and cost management. Thus, managers should be look and try other alternative method such as activity based costing (ABC) which is this method will be provides more accurate and reliable information for decision making. This method may be can replace the traditional costing method that have been using for a long time ago.

2. BACKGROUND OF AVTIVITY BASED COSTING ( ABC )

Activity based costing ( ABC ) method have been introduced by Kaplan and Cooper in Harvard Business School. This method were formalised and disseminated in year 1984 as alternative to traditional costing method. Since then, there has been a great deal of interest from managers, academics and especially in business and manufacturing sectors. It is related with costing product sector which calculation of direct cost such as material cost, labour cost, and others direct cost are same with traditional method. But the main concepts in ABC method are introduction to concepts of overhead cost that can be change compare to traditional costing method that assumed all of overhead cost are fixed and need to be distributed base on production quantity. Actually, ABC method distributed all of overhead cost to cost pool and cost driver who we will study in this task.

3. COSTING METHOD PRODUCT

In costing accounting system products, there are two main costs which are counted to produce a product, that are direct cost and overhead cost (figure 1). Traditional costing method and activity based costing ( ABC ) using the same approach within calculation direct cost. But there is clear distinction between these methods that is within calculation and allocation of overhead cost. Thus, we will be discuss and look at the difference between traditional costing method and activity based coasting ( ABC ).

Before the procedures of cost ascertainment are discussed on these methods, certain preliminary definitions need to be known. (T.Lucey, 1992, pg7) define that terms as follows:

Cost unit - This is a unit of output or service to which costs can be related. The unit chosen is what is most relevant for the activities of the organisation.

Examples:

Within a given organisation there may be several different cost units in order to cost various products or activities.

As cost are incurred they are classified in various way by means of the accounts coding system. An important, primary classification is that into direct cost and indirect cost.

Direct cost - These costs comprising direct materials, direct labour, and direct expenses, are those which can be directly identified with a job, a product or service.

Examples:

The total of direct costs is known as prime cost thus.

Indirect cost - All material, labour and expense expenditure which cannot be identified with the product are termed indirect costs. The total of indirect cost is known as overhead which is normally separated into categories such as Production Overhead, Administration overhead, Selling Overheads and so on.

3.1 TRADITIONAL COSTING METHOD

As we know, in the traditional costing method there are two main costs that are direct cost (which include material cost, labour cost and others expenses that related with direct cost) and overhead cost. To get the total amount for product per unit that had been produced, these cost elements must be totalled. However, this method will be expressed by the figure 3.

Refer to figure 3 and 4 above, overhead cost per unit product normally counted based on labour hour or machine hour or both that have been used by a product. Normally distribution overhead cost were made based on assumption assuming that the overhead cost directly proportional to labour hour or machine hour or both. If total cost overhead smaller than material cost and labour cost, traditional costing able to calculate product cost nearly accurate. Since this situation and overhead cost in this nowadays industry were a bit massive cost, using overhead cost method based on labour hour or machine hour will affect the product cost calculation. This is because product that were produced in high quantity using labour hour and machine hour does not necessarily need big sources and big overhead cost. On the other hand, there is low quantity production but, using complex processes, and need big overhead cost such as; high inspection cost; high setup cost; high handling cost; and high planning cost. Due to this, traditional cost accounting method, although can collect and report direct cost total analytically, failed provide sure cost distribution products accurately.

3.2 ACTIVITY BASED COSTING METHOD

What is it? And how does ABC work?

( Leslie Chadwick, 1998) state that CIMA has defined activity based costing as:

" cost attribution to cost unit on the basis of benefit received from direct activities e.g. ordering, set-up, assuring quality".

CIMA (Chartered Institute of Management Accountings) official Terminology, 1991

( CAM-I, 1990) has defined activity based costing as:

"A method that assigns cost activities to cost objects such a product, services and customers, based on two main stages. The first stage pools cost to activities according to each activity`s consumption of recourse. The second stage assigns cost to cost objects based on their use of activities."

Lecture slide

"A method of calculating the cost of a business by focusing on the actual cost of activities, thereby producing an estimate of the cost of individual products or services."

BNET UK - http://dictionary.bnet.com/definition/activity+based+costing.html

Accessed 15 January 2010

Refer the definition above, Activity Based Costing (ABC) is concerned with the consumption of resources and need to:

Understand the behaviour of overhead costs;

Ascertain which activities cause these overhead costs.

Activity based costing (ABC) force the management in organization to consider what the main causes to cost. This method uses multiple cost drivers in order to attribute cost to activities and cost object. Thus, overhead cost can be related to the activities which cause them, such as what object which drive them and make them happen until make a product or service. Figure 5 should help us to understand how activity based costing applied.

The question below can help to understand how activity based costing and traditional method applied. Besides, the answer will show comparison between these methods.

Entertainment Corporation manufactures subwoofer and home theatre.The following information available.

Entertainment is considering switching from one overhead rate based on labour hour to activity-based costing.

Instructions: Perform the following analyses for these two components of overhead.

Computed total machine setups and inspection cost assigned to each product, using a single overhead rate.

Computed total machine setups and inspection cost assigned to each product, using activity-based costing.

Comment on your finding based on answer (a) and (b).

Answer:

Traditional method (A single overhead rate )

A single overhead rate = Total Cost

Labour Hour

= £ 16000 + £ 27000

2600 + 2400

= £ 43 000

5000

= £ 8.60/ hour labour

So, overhead cost to :

Subwoofer = £ 8.60/hour labour X 2600 ( labour hours)

= £ 22,360

Home Theatre = £ 8.60/ hour labour X 2400 ( labour hours )

= £ 20,640

Overhead rate using activity-based costing (ABC )

machine setup = £ 16,000

200 + 600

= £ 20/setup

inspections = £ 27,000

250 + 500

= £ 36/inspection

So, cost overhead to :

Subwoofer = ( £ 20 x 200 ) + ( £36 x 250 )

= £ 4,000 + £ 9,000

= £ 13,000

Home theatre = ( £ 20 x 600 ) + ( £ 36 x 500 )

= £ 12,000 + £ 18,000

= £ 30,000

To product subwoofer, total cost under ABC method is lower than traditional method

While for product home theatre, total cost under ABC higher than traditional method

However, using a single rate or traditional method to ABC method is more accurate from distribution aspect made based on cause and effect

4. IMPLEMENTATION OF ABC METHOD

There are seven steps to implement the activity based costing method:

Identify the resource centers used for the design and development.

Identify the overall cost associated with these resource centres.

Find the cost drivers for the resource centres.

Identify the activities that participate in the design and development process.

Calculate the cost of the activities based on resource consumption.

Find the activity cost drivers and calculate their values.

Calculate the overall process costs based on the activities performed.

Firstly, to implement activity based costing is identify cost centers which used directly to produce a product until the product complete. Secondly, identify and analyze indirect cost and calculate their cost-driver rates. This step shows overhead cost need to be allocated to the end product by indentify indirect resource cost drivers. Thirdly, assign resource to each cost center and determine cost center driver rates. For this step, cost of indirect resource is allocated to cost centers and total cost of each cost center is calculated. One cost driver is indentified for each cost center while one driver rate is obtained for each cost center. Fourthly, indentify activities take place in the product development process. Fifthly, analyze each activity and find the total cost for each activity. This cost is calculated by using the cost-center drivers` rates multiplied by each activity. Sixthly, define activity drivers for each activity and find activity cost driver rate. An activity cost-driver is any factor that directly explain the cost incurred by the activity. Finally, estimate the cost of new parts via activity-cost-drivers spent.

5. DIFFERENCES BETWEEN TRADITIONAL AND ABC METHOD

There are several differences between traditional and activity based costing method such as in unit products that were produce. In this situation, activity based costing useful in one product environment while traditional method is valuable in multi-product environment. Besides that, arise distinguish in the management which is traditional method focus more to external reporting while ABC method focus to internal management on decision making in organisation. However traditional method using structure-oriented, it is difference by activity based costing which is using process-oriented on produce the product. Implementation traditional method in manufacturing company is inexpensive compared by using ABC method which is need to spend relatively expenses. Besides that the schedule 1 shows comparison to determinant activity cost pools on overhead cost between traditional and activity based costing method

6. USEFULNESS OF ABC

Introduction to activity based costing method as alternative on traditional method to manufacturing company today useful from aspect production of products. Thus, there are many usefulness of ABC that are it`s can improve the accuracy and relevance of product costing and it also can determine timely cost information on production process. Using activity based costing method bring managers and company to know which is this method better understanding overhead cost compare to traditional method that was allocated overhead cost to one base or activity (such as labour hour or machine hour). Besides that, it also utilized unit cost rather than just total cost and makes visible waste and non-value added within each process of manufacturing product.

7.LIMITATION OR BARRIERS OF ABC

Before using or implement activity based costing method on manufacturing product, managers or manufacturing company need to consider limitations or barriers were arise. For example, to implement the method managers need to know about how long it will be taken? It is because it will take more time consuming to collect the data and complete the processes. Furthermore, processes that will be used (ABC) need to high expenses and costly for each of life cycle product within to determine overhead cost. Besides that, there are barriers to change from traditional method to activity based costing method. For example, to small company that always produce are goods and services in small quantity could not able to implement activity based costing method in organisation because the cost for this process is costly and not worth it to company.

8.CONCLUSION

Activity based costing (ABC) method have been introduced by Kaplan and Cooper as alternative to traditional costing method were helped many parties especially to manufacturing company. It is related with costing product sector which calculation of direct cost such as material cost, labour cost, and others direct cost are same with traditional method. But the main concepts in ABC method are introduction to concepts of overhead cost that can be change compare to traditional costing method that assumed all of overhead cost are fixed and need to be distributed base on production quantity. Actually, ABC method distributed all of overhead cost to cost pool and cost driver on processes of product. Besides that, to implement the activity based costing in manufacturing product 7 step have been created as guide line. Although, there are some differences between traditional and ABC method and also have usefulness and barriers to implementation this method. However, ABC method is a big improvement when compared with total absorption costing, providing cost which are more accurate and some degree of control over the activities which diver them.

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